The correlation between currencies

The study of the different currency crosses concordance is sometimes neglected or not well understood but it is a very important point that can provoke a lot of problems if it is not well assimilated.

The coefficient of correlation is the degree two variables are linked. This coefficient always fluctuates between -1 and 1, sometimes we use the interval -100%; +100% too. Variables that have a coefficient of correlation equal to 1 (= 100%) will change in the same way and with the same extent. Variables with a coefficient of correlation equal to -1 (= -100%) will change in the opposite side and with the same extent. Variables with a coefficient of correlation equal to 0 ( = 0%) will no longer be correlated and will change in totally different ways. In general, from +/- 0.5 a coefficient of correlation, we consider that two assets are correlated and that they are strongly correlated from +/- 0.75.

The most important aspect of the correlation studies is the connection with the risk management. The study of a portfolio risk management implies the portfolio diversification. In fact, a well diversified portfolio limits the volatility if the whole portfolio so limits risks. But the diversification quality is in inverse proportion to the coefficient of correlation absolute value.

Thus two assets in a portfolio that have a correlation rate equal to 0.95 are so much linked that at a risk level it means nearly to have twice the same position. Very often, they’re will be either winning position, or losing positions, so it isn’t an efficient diversification.

Here are some correlations 01/07/2009 (from: dailyfx.com) :

The first cross table shows the different correlations at a given moment; and the second one shows the evolution in time of these correlations. In fact, correlations are not static, they can increase or decrease and it will be interesting to survey them in time.

This data shows that taking a long position on the EUR/USD and at the same time a long position on AUD/USD, GBP/USD or NZD/USD is the same as duplicated the position that generates an important risk. It isn’t forbidden to do it is necessary to adapt accordingly the size of the positions. If in general, we take position for 2% of capital, in this case you must for example take position at 1% on the EUR/USD and at 1% on the GBP/USD or chose one of the cross. The portfolio global risk will remain in the limit of the 2% that would not be the case with two 2% positions, as each is accumulated.

For the USD/CHF or USD/CAD that are conversely correlated to the EUR/USD, so you’ll have to pay attention to the aggregation of a short position on USD/CHF or USD/CAD and a long position on EUR/USD. A contrario, having a position on the EUR/USD and at the same time another one on the USD/JPY doesn’t increase a lot the risk level; so these two crosses are strongly not correlated.

Another more advanced aspect of the correlations is their use to work on several crosses. For a beginner, he’d better to concentrate on a single cross to understand how the market works but then, the trading can be done on two crosses or more. With sufficiently correlated crosses (or sufficiently inversely correlated), it will be possible to chose the cross that has the best relative force.

For example, if the exchange rates EUR/USD, GBP/USD and AUD/USD are chosen and if a long signal appears at the same time on these three crosses, fact that is really probable, it will be interesting to choose among these three crosses, the one that will have the best bullish strength. Conversely for a short signal, the chosen cross will be the one that tends to decrease. In general, this will maximise benefits. This practice is not natural, instinctively the cross that retraces the more (so the less adapted) will generally be chosen because it will seem to have more potential but in most of the cases it will be the one that will evolve slower and will give less benefits.

Nevertheless, this practice is to be avoided at the beginning, it would be better to concentrate on a single cross, overall in day trading, because it requires looking at several crosses at the same time; it requires an appropriate computing equipment and a certain habit.