Currency pairs in the forex market do not move the same way to each other. In most cases, foreign economic conditions, interest rates, and price changes affect not only one currency pair but also many different currency pairs.
Every factor is partly interrelated with each other and knowing the extent of this interaction or the direction is useful for developing trading strategies and use as a trading tool. Unless you trade only one currency pair, it is vital to understand the correlation between currencies.
The correlation is calculated using price data and the correlation coefficients to measure the relationship between different currencies. The information from these correlation coefficients helps traders diversify their portfolios or increase their positions to other currency pairs. It enables traders to know the extent of risk exposure, means to increase profit and prevent inefficient trading.
Usefulness of Correlation
Identifying the correlation between currency pairs in a trader’s portfolio is a perfect way to measure the extent of the risk of exposure. While you may think that you are diversifying your portfolio by investing in different currency pairs, most currency pairs in the portfolio tend to move in the same direction or the opposite direction. The correlation between currencies can be strong or weak, and this correlation can last for several months or even years.
Correlation coefficient numbers allow us to estimate how closely currency pairs move in the same or different directions over a particular period. The correlation coefficient values take a small number and have a value of at least -1.0 to a wedge of +1.0. The correlation coefficient value is close to the +1 value, meaning that the two pairs of currencies move together with the same directionality.
For example, USD/JPY and USD/CHF have shown a correlation coefficient of +0.70 over the past month. Consider converting them into percentages if you are insensitive to values in the form of a decimal number. It can then be determined that there is a 70% correlation between the two currencies. The correlation coefficient value close to +1.0 moves in the same direction. On the contrary, a discount relative to -1.0 indicates the “reverse correlation” between the two currency pairs, which means that the exchange rate moves the other way around.
A strategy of buying one currency pair and selling another may not be desirable. This is because the value of the buy currency pair increases in the upward trend, but the other side of the currency pairs’ value decreases, offsetting the rise in the buy currency pair. This buying/selling strategy does not guarantee the trader’s profit, nor does it precisely zero the loss because the two currency pairs have different pip values. In this combination of portfolios with similar movements between the two currency pairs, the establishment of opposite buying/selling positions can reduce profits and even cause losses.
A positive correlation is not the only useful measurement of connectivity between pairs of currency. A negative correlation is also helpful in building a currency portfolio. In the following example, consider a case with a high negative correlation instead of a positive correlation. Contrary to positive correlation, the closer the correlation coefficient approaches -1, the motion of the call pair is connected in the opposite direction.
Let’s look at the case of EUR/USD, which correlates negatively with USD/CHF. The correlation coefficient between the two currency pairs is -0.80 on a one-year basis and -0.90 every month. What this number means is that the two currency pairs are highly inclined to move in opposite directions. Thus, when two currency pairs take opposite positions, it is equivalent to building positions in the same direction on two currency pairs with high positive correlations. Such a negatively correlated buy-and-sell strategy has the same effect as increasing a position, which consequently increases the portfolio’s risk exposure.
Changing Correlation Coefficient Values
Anyone who has experienced foreign exchange transactions at least once would know that the foreign exchange market is very dynamic. Various economic conditions, prices, and psychology are changing every day. What should be remembered when analysing the correlation between currencies according to the changing foreign exchange market characteristics is that these critical variables change quickly over time. The strong correlation observed today may differ from that observed next month.
As the foreign exchange market environment continues to change, it is imperative to recognise market trends to use the correlation coefficient analysis method. For example, for AUD/USD and GBP/USD, the correlation coefficient observed for a month is 0.08. This low correlation indicates that the movement between the two currency pairs moves without affecting each other.
However, calculating the three-month correlation coefficient between the two currency pairs increases to 0.24, and the six-month correlation coefficient, calculated in the same way, increases sharply to 0.41, and the one-year correlation coefficient to 0.25. What can be seen from this example is that the relationship between the two currency pairs is collapsing in the short term. Although there is a substantial amount of correlation, in the long run, there is little correlation in a short time.
How to Calculate the Correlation
between Currency pairs?
As we have seen before, since the correlation between currency pairs changes over time, we need to update the correlation values to recognise the trends like strength and direction. The simplest way is to do this is by using the Excel program.
The Excel program can use the correlation coefficient function by selecting a specific period with the currency’s price data to determine the correlation coefficient. Based on the data for one year, six months, three months and one month, we can draw a comprehensive picture of the similarities and differences between the two currencies. We should use many of these data to determine what and how to use them.
Here are the steps to calculate the correlation!
1. Collect price data for two currency pairs.To make it easier to recognize at a glance, the weekly closing GBP data are arranged in one column, and the USD data is arranged on the other.
2. Set the period for how long, and type the excel function ‘=CORREAL’ in the space below the last column where the two periods match.
3. Then select all GBP price data, enter a comma, and select all USD price data (=correl(GBP data, USD data).
4. The values derived here are the correlation coefficients of the two currency pairs. Although these obtained correlation coefficient values are not required to be updated daily, it is recommended to update them once every other week or at least once a month.