2011-11-18 12:16:32
Posted: May 10, 2010
To be an effective trader, understanding your entire portfolio's sensitivity to
market volatility is important. This is particularly so when trading forex.
Because currencies are priced in pairs, no single pair trades completely
independent of the others. Once you are aware of these correlations and how
they change, you can use them control your overall portfolio's exposure. (For a
guide to all things forex, check out our Investopedia Special Feature: Forex.)
Defining Correlation
The reason for the interdependence of currency pairs is easy to see: if you
were trading the British pound against the Japanese yen (GBP/JPY pair), for
example, you are actually trading a derivative of the GBP/USD and USD/JPY
pairs; therefore, GBP/JPY must be somewhat correlated to one if not both of
these other currency pairs. However, the interdependence among currencies stems
from more than the simple fact that they are in pairs. While some currency
pairs will move in tandem, other currency pairs may move in opposite
directions, which is in essence the result of more complex forces.
Correlation, in the financial world, is the statistical measure of the
relationship between two securities. The correlation coefficient ranges between
-1 and +1. A correlation of +1 implies that the two currency pairs will move in
the same direction 100% of the time. A correlation of -1 implies the two
currency pairs will move in the opposite direction 100% of the time. A
correlation of zero implies that the relationship between the currency pairs is
completely random.
Reading The Correlation Table
With this knowledge of correlations in mind, let's look at the following
tables, each showing correlations between the major currency pairs during the
month of February 2010.
The upper table above shows that over the month of February (one month) EUR/USD
and GBP/USD had a very strong positive correlation of 0.95. This implies that
when the EUR/USD rallies, the GBP/USD has also rallied 95% of the time. Over
the past 6 months though, the correlation was weaker (0.66) but in the long run
(1 year) the two currency pairs still have a strong correlation.
By contrast, the EUR/USD and USD/CHF had a near-perfect negative correlation of
-1.00. This implies that 100% of the time, when the EUR/USD rallied, USD/CHF
sold off. This relationship even holds true over longer periods as the
correlation figures remain relatively stable.
Yet correlations do not always remain stable. Take USD/CAD and USD/CHF, for
example. With a coefficient of 0.95, they had a strong positive correlation
over the past year, but the relationship deteriorated significantly in February
2010 for a number of reasons, including the rally in oil prices and the
hawkishness of the Bank of Canada. (For more, see Using Interest Rate Parity To
Trade Forex.)
Correlations Do Change
It is clear then that correlations do change, which makes following the shift
in correlations even more important. Sentiment and global economic factors are
very dynamic and can even change on a daily basis. Strong correlations today
might not be in line with the longer-term correlation between two currency
pairs. That is why taking a look at the six-month trailing correlation is also
very important. This provides a clearer perspective on the average six-month
relationship between the two currency pairs, which tends to be more accurate.
Correlations change for a variety of reasons, the most common of which include
diverging monetary policies, a certain currency pair s sensitivity to commodity
prices, as well as unique economic and political factors.
Here is a table showing the six-month trailing correlations that EUR/USD shares
with other pairs:
Calculating Correlations Yourself
The best way to keep current on the direction and strength of your correlation
pairings is to calculate them yourself. This may sound difficult, but it's
actually quite simple.
To calculate a simple correlation, just use a spreadsheet, like Microsoft
Excel. Many charting packages (even some free ones) allow you to download
historical daily currency prices, which you can then transport into Excel. In
Excel, just use the correlation function, which is =CORREL(range 1, range 2).
The one-year, six-, three- and one-month trailing readings give the most
comprehensive view of the similarities and differences in correlation over
time; however, you can decide for yourself which or how many of these readings
you want to analyze.
Here is the correlation-calculation process reviewed step by step:
1. Get the pricing data for your two currency pairs; say they are GBP/USD and
USD/JPY
2. Make two individual columns, each labeled with one of these pairs. Then fill
in the columns with the past daily prices that occurred for each pair over the
time period you are analyzing
3. At the bottom of the one of the columns, in an empty slot, type in =CORREL(
4. Highlight all of the data in one of the pricing columns; you should get a
range of cells in the formula box.
5. Type in comma
6. Repeat steps 3-5 for the other currency
7. Close the formula so that it looks like =CORREL(A1:A50,B1:B50)
8. The number that is produced represents the correlation between the two
currency pairs
Even though correlations change, it is not necessary to update your numbers
every day, updating once every few weeks or at the very least once a month is
generally a good idea.
How To Use It To Manage Exposure
Now that you know how to calculate correlations, it is time to go over how to
use them to your advantage.
First, they can help you avoid entering two positions that cancel each other
out, For instance, by knowing that EUR/USD and USD/CHF move in opposite
directions nearly 100% of time, you would see that having a portfolio of long
EUR/USD and long USD/CHF is the same as having virtually no position - this is
true because, as the correlation indicates, when the EUR/USD rallies, USD/CHF
will undergo a selloff. On the other hand, holding long EUR/USD and long AUD/
USD or NZD/USD is similar to doubling up on the same position since the
correlations are so strong. (Learn more in Forex: Wading Into The Currency
Market.)
Diversification is another factor to consider. Since the EUR/USD and AUD/USD
correlation is traditionally not 100% positive, traders can use these two pairs
to diversify their risk somewhat while still maintaining a core directional
view. For example, to express a bearish outlook on the USD, the trader, instead
of buying two lots of the EUR/USD, may buy one lot of the EUR/USD and one lot
of the AUD/USD. The imperfect correlation between the two different currency
pairs allows for more diversification and marginally lower risk. Furthermore,
the central banks of Australia and Europe have different monetary policy
biases, so in the event of a dollar rally, the Australian dollar may be less
affected than the Euro, or vice versa.
A trader can use also different pip or point values for his or her advantage.
Lets consider the EUR/USD and USD/CHF once again. They have a near-perfect
negative correlation, but the value of a pip move in the EUR/USD is $10 for a
lot of 100,000 units while the value of a pip move in USD/CHF is $9.24 for the
same number of units. This implies traders can use USD/CHF to hedge EUR/USD
exposure.
Here's how the hedge would work: say a trader had a portfolio of one short EUR/
USD lot of 100,000 units and one short USD/CHF lot of 100,000 units. When the
EUR/USD increases by ten pips or points, the trader would be down $100 on the
position. However, since USDCHF moves opposite to the EUR/USD, the short USD/
CHF position would be profitable, likely moving close to ten pips higher, up
$92.40. This would turn the net loss of the portfolio into -$7.60 instead of
-$100. Of course, this hedge also means smaller profits in the event of a
strong EUR/USD sell-off, but in the worst-case scenario, losses become
relatively lower.
Regardless of whether you are looking to diversify your positions or find
alternate pairs to leverage your view, it is very important to be aware of the
correlation between various currency pairs and their shifting trends. This is
powerful knowledge for all professional traders holding more than one currency
pair in their trading accounts. Such knowledge helps traders, diversify, hedge
or double up on profits.
The Bottom Line
To be an effective trader, it is important to understand how different currency
pairs move in relation to each other so traders can better understand their
exposure. Some currency pairs move in tandem with each other, while others may
be polar opposites. Learning about currency correlation helps traders manage
their portfolios more appropriately. Regardless of your trading strategy and
whether you are looking to diversify your positions or find alternate pairs to
leverage your view, it is very important to keep in mind the correlation
between various currency pairs and their shifting trends. (For more, check out
our Forex Tutorial.)
by Kathy Lien