Forex 1

Currency Correlation and Its Uses

The interesting thing about the currency market is that they trade in pairs this means that one currency cannot possibly be traded independently of the other. Both the pairs are correlated and knowledge about this correlation between the currency pairs can help traders the exposure of the portfolio.

Before one start using correlation as a potent told to predict market movement it is essential to understand the meaning of correlation. The statistical definition of correlation is the measure of relationship between two values. In the financial markets this would equate to the measure of relationship between two securities. to explain the concept f correlation further lets take the examples of a few currency pairs. If you are trading the AUS/USD, this pair is a sort of derivative of two other pairs AUD/JPY and GBP/USD. This means that AUS/USD is in correlation with at least one if not both of these pairs. The correlation among currencies is because they trade in pairs. The movement of some currencies is directly proportional to the move in the value of the other currency. But in some other cases the currencies may be inversely proportional to each other.

The measure of correlation used in the financial world is called the coefficient of correlation. The value of this measure can range between +1 and -1. If the value of the coefficient of correlation is positive it means that the currencies will move in the same direction if the value is zero it indicates no correlation that means the values will move randomly and independently of each other. If the value of the correlation coefficient is -1 it means that the values are dependent on each other but they will move in opposite directions from each other.

So if the correlation table for a particular month USD/JPY and EUR/USD had a strong correlation of +0.95 it means that if the USD/JPY rallies so will the EUR/USD and it will do so 95% of the times. On the other hand if the correlation coefficient for these pairs would be -0.95 it would means that when the USD/JPY rallies the EUR/USD will go through a selloff and this will happen 95% of the times. The biggest advantage of using this measure is that the correlation figures remain almost stable over long periods. However this is not a hard and fast rule and the correlation figures between two currency pairs may change quite quickly depending on certain factors like government’s intentions to increase interest rates or political instability. The other influencing factors are market sentiments and economic factors, global as well as country specific and these factors can change more often than you think possible. So, its imperative to keep abreast of any changes or shifts in correlation figures.

Another aspect to consider is that even if a strong correlation exists over a short period of time it may not be in tandem with the correlation over a longer period. So the correlation values that hold true today may not necessarily be in line with the long term correlation figures between the two currency pairs. So its is important to look at the past values of correlation between the pairs and a trader can do so by taking a look at the six month trailing correlation. Thse figures will be more accurate and will give the trader an insight into the average correlation over a period of six months between the pairs. As mentioned above there are numerous reasons for a change in the correlation values.

If you two currency pairs which have a perfectly negative correlation of -1 it means that holding these two pairs will be like holding no position since they both cancel each other out. But if the correlation is perfectly positive at +1 t is equivalent to doubling up. You can also use correlation to maintain a core directional value. Since two currency pairs rarely display perfect positive correlation a trader can invest in two pairs instead of one which will diversify the portfolio.

Correlation can also be used for hedging suppose the value of a pip move of the EUR/USD is $9 for a lot of 100,000 units and if this pair has a almost perfect negative correlation with another currency pair AUD/USD and for this currency pair if the value of a pip move is $8.5 per 100,000 lot then the trader can use the EUR/USD to hedge against EUR/USD exposure.

Correlation is a very important factor that merits the attention of every trader whether you want to double up, hedge or diversify.