Defining Correlation in Finance
Correlation in finance is the statistical measure of the degree to which two securities are related to each other. This relationship is measured during a certain time period.
Correlations are expressed on a scale of -1.0 to +1.0, as follows:
■ +1.0, two assets move in an identical direction, 100% of all times
■ +0.0, two assets move in random directions
■ -1.0, two assets move in the exact opposite direction, 100% of all times
For example, EURUSD and GBPUSD have a positive correlation between +0.8 and +0.9. That means there is an 85% probability that these two pairs shall trade in the same direction. If we exclude the news-trading hours, this correlation may become even stronger.
The Dependency of Forex Pairs
As Forex currencies are quoted in pairs, there is no individual pair completely independent from all the others. Correlations between pairs can be measured in various timeframes, but longer-term correlations (6-month or more) should be considered more reliable.
The knowledge of the basic correlations between Forex pairs is helpful because:
Group of Currencies
In general, there are some groups of currencies that tend to trade in the same direction. For example, this is a very strong group:
■ EURUSD, GBPUSD, AUDUSD, and NZDUSD
In the chart below (source: Google-Finance) you can see graphically the correlation of these 4 pairs during the period 2008-2015. Although AUDUSD and NZDUSD have performed better there is a clear correlation in the trend direction of all pairs.
Chart: EURUSD, GBPUSD, AUDUSD and NZDUSD Correlation 2008-2015
This is happening as USD is used as the base currency or else as ‘money’ in the Foreign Exchange. That fact itself creates a general trend in the market, which either favors the USD and all the above pairs are moving in downtrends, or it is against the USD, and all the above pairs are moving in uptrends. Here is some proof regarding the importance of US Dollar in the Forex market.
Table: Most traded currencies by value (Source: Wikipedia)
CURRENCY |
SYMBOL |
% VALUE PARTICIPATION |
|
1. |
United States dollar |
USD |
87.0% |
2. |
Euro |
EUR |
33.4% |
3. |
Japanese yen |
JPY |
23.0% |
4. |
British Pound sterling |
GBP |
11.8% |
Correlations are Formed Dynamically
Some correlations between Forex pairs have a historical character, but that does not mean they are historically stable. On the contrary, new political and economic conditions may alter the correlation between two Forex pairs. This is especially true as concerns commodity currencies, such as AUD, CAD, and NZD, which show extreme sensitivity to price changes of particular commodities. Furthermore, changes in the level of interest rates (monetary policy) can play a decisive role as concerns correlational changes.
Check live Forex pairs correlations in the below links:
» http://www.myfxbook.com/forex-market/correlation
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Historical Correlations of the Forex Majors
These are some strong historical correlations between Forex majors, and between Forex Majors and other markets:
■ EURUSD
EURUSD has a high positive correlation with GBPUSD and a negative correlation with USDCHF and USDJPY.
■ GBPUSD
GBPUSD has a high positive correlation with EURUSD and a negative correlation with USDCHF and USDJPY.
USDJPY is negatively correlated with EURUSD and GBPUSD. But there is also another form of correlation regarding USDJPY. As the Japanese interest rates are traditionally very low, American investors tend to borrow in JPY in order to buy US stocks. Therefore, USDJPY is considered to be negatively correlated with the US investor’s sentiment and the general political sentiment in the US.
■ USDCHF
The USDCHF is negatively correlated with EURUSD and GBPUSD.
■ USDCAD
The USDCAD is very sensitive to the changes in oil prices as the Canadian economy is a major oil-exporting economy. Moreover, USDCAD is highly negatively correlated with AUDUSD and NZDUSD and less with EURUSD and GBP/USD.
■ AUDUSD
AUDUSD is highly and positively correlated with NZDUSD. The Australian and New Zeeland economies are very sensitive to a commodity price change, and therefore, are negatively correlated with USDCAD.
Some Useful Conclusions Regarding this Forex Correlation Analysis
These could be some useful conclusions regarding correlations between Forex pairs:
■ Forex Pairs Correlations
George Protonotarios, Financial Analyst
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