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Correlation of currency pairs: definition, calculation, application

The effectiveness of a trader depends on many factors, but one of the most significant determining his professionalism is the ability to calculate and analyze statistical indicators. For example, correlation of currency pairs helps to determine how sensitive your overall trading portfolio is to changes in the market at the moment. If it turns out that any surge will lead to a rapid decline in profitability, measures should be taken immediately. And without knowledge of the indicators hiding under the term Forex correlation, it will not be possible to correct the behavior without errors. Knowledge of trends in the relationship between currencies provides reliable protection of the trading portfolio risks.

Introduction to the correlation of currency pairs

Answering the question: why do currency pairs depend on each other-it is enough to give a fairly simple example to understand. Trading the pound against the national currency of Japan, the yen, can be represented as follows: GBR/JPY corresponds to GBR/USD and USD/JPY. This expression demonstrates that the initial rate of GBR/JPY will be tied to one or both of the pairs, between them there is an obvious correlation of Forex. However, such simplification, although it explains the essence of the phenomenon, does not always reflect the real behavior of currencies. Their pairs can increase or decrease in parallel, but there is a situation and the opposite, when more complex and unpredictable factors come into play.

In General, the correlation of currency pairs implies an indicator ranging from -1 to 1, the financial meaning of which is to demonstrate the relationship between the two assets. If the correlation takes the value -1, it is said about the negative dependence: the movement of such currency pair is predetermined by 100% and has the opposite direction. The correlation of the currency pairs with a value of 0 implies that their behavior has nothing to do with each other.

Forex correlation in tabular form

Once you have understood the definition of correlation and its meaning in the Annex to the financial world, you should read the specific examples. The tables below show in a structured way what the correlation of currency pairs was during February 2010.

According to the data from the first table, it can be seen that the Forex correlation between EUR/USD and GBR/USD for February takes a significant positive value of 0.95. Thus, the increase in the value of EUR/USD in 95% of cases will entail the GBR / USD rally. In a longer period of 6 months, the correlation of currency pairs is reduced to 0.66. Nevertheless, the annual forecast still shows a strong dependence, which is pointless to deny.

If we take as an example such pairs as EUR/USD and USD / CHF, we see a negative correlation, and its value is very large and is -1. That is, with a 100% probability, the decline in the USD/CHF ratio will be accompanied by an increase in EUR/USD. This trend will be manifested over a long period, since in all the considered segments the correlation value is practically unchanged.

However, the situation described, when the relationship is only slightly weakened or enhanced, is not always reflected in reality. Other currency pairs can be much less stable. USD/CAD and USD/CHF in the past year were highly correlated among themselves, according to their coefficient was 0.95. But the February 2010 figure shows a significant reduction in the strength of the link, which may be due to various reasons, including the increase in the cost of a barrel of oil and changes in the policy of the Bank of Canada in the direction of more stringent and aggressive measures.
Currency pair correlation fluctuations

As already shown in the examples, the Forex correlation is quite variable and unstable. In this regard, the importance of continuous monitoring of its indicators increases dramatically. After all, the mood of the foreign exchange market, as well as the state of the world economy are volatile factors that are subject to daily changes. The strongest, even perfect correlation of currency pairs today does not guarantee the same behavior in the longer term. The most informative is considered to be the sliding correlation coefficient calculated on the basis of data for 6 months. With it, you can get a more accurate and reliable forecast for the near future between some currency pairs.

Changes in correlation are manifested due to various factors, the greatest influence is exerted by the monetary policy of States, changes in prices for various groups of goods and a number of other economic and political reasons.

The following table shows what was the moving correlation of currency pairs for EUR / USD for six months.

The calculation of the Forex correlation

You want something done right, you do it yourself. This capital truth is quite true in relation to obtaining specific figures, which are accepted by the correlation of currency pairs. Despite the apparent complexity, the calculation of correlation coefficients is not difficult if you know the correct sequence of actions.

Forex correlation can be obtained in just a few clicks using a spreadsheet, for example, such as Excel. The initial download of exchange rate values is carried out with the help of graphical software packages, many of which are completely free, and then imported into Excel. Then it is enough to use the built-in spreadsheet tools, namely the correlation function. In versions in English it is “=CORREL (named range1, range2)”, in Russian Excle’e “=correl (array1, array2)”.

As a rule, the calculation of the moving correlation is carried out for a period of one year, six, three and one month. This information set is the most useful and convenient for analysis. However, individual strategies and habits of a particular trader may suggest a different time frame, as well as the number of estimated indicators.

The sequence of steps in which the correlation of currency pairs will be obtained is as follows:

Obtaining price data on currency pairs of interest (for example, GBR / USD and USD / JPY);
Create individual columns in a spreadsheet under the corresponding pair of headings.
Filling columns with daily prices for the period selected for the analysis.
Introduction to the column base of the CORREL or correl formula.
Select the desired range of cells, adding it to the formula. You should get a string like: = correl (A1:A60, B1:B60).

The resulting value reflects the interdependence between the selected currency pairs.

Despite the fact that the correlation index is constantly subject to changes, daily recalculation is not necessary. It is enough to update the data once a couple of weeks or a month.
The application of the indicator of currency pairs correlation

So, when the theoretical training in terminology and calculations of correlation is completed, you can begin to describe the practical use of existing knowledge.

Knowing the correlation coefficient can save you from many unreasonable decisions, including opening positions, profit and loss from which are balanced. For example, the correlation of currency pairs EUR/USD and USD/CHF is close to -1, that is, almost all the time when the value of one pair increases, the price of the second one decreases. Thus, a long deal on EUR/USD and the same deal on USD / CHF will become meaningless: after all, the sharp rally of the first position will be balanced by the sale of the second. But another option, a long deal on EUR/USD and it is on AUD/USD (as an option, NZD / USD), will result in almost doubling the position, due to the strong correlation with the plus sign.

The use of correlation coefficients also provides some reduction of currency risks by diversifying reserves. As an example, take the pair EUR/USD and AUD / USD. Their relationship is positive, but does not reach the value of 100%. Therefore, the use of these pairs will be an excellent opportunity to maintain a certain bias dictated by the market, but to face fewer losses under unfavorable circumstances. If the trader faces the task of reflecting the bearish bias in the us currency, it would be more logical to buy not two lots of EUR/USD pair, but one lot of EUR/USD and AUD/USD pairs. The incomplete dependence of currency pairs necessitates the allocation of foreign exchange reserves in the hope of a smaller possible loss. In addition to the fact that the correlation of currency pairs in this case is not perfect, the difference in the monetary policy of Australia and the European region is also taken into account. Thus, a jump in the dollar may trigger a fall in the Euro, but the Australian currency will be more stable.

Also, information on correlation is reflected in the calculation of the cost of trading positions. Returning to the example, in which the pairs EUR/USD and USD/CHF appear, let us remember their almost complete negative relationship and give the cost of each item. So, for EUR/USD price is$ 10, in the pair USD / CHF standard lot is$9.24. Thus, the transaction currency pair USD/CHF implies the possibility of a successful hedging of risks in the implementation of the transaction for EUR/USD.

Imagine that in the trading portfolio of a market participant there is a short position for one lot EUR/USD and the same position for USD / CHF. In case of increase of exchange rate EUR/USD 10 pips, the trader’s losses in the announced positions will be$100. But given the opposite movement of the pair USD / CHF, the trader also makes a profit of about 10 points, which in monetary terms is 92.4$. That is, the loss in General for the trader would be reduced from$ 100 to only$7.6. The negative scenario becomes much less unprofitable. But such hedging has a catch: with a significant decrease in the EUR/USD rate, the profit will also decrease due to losses on USD/CHF.

It is obvious that whatever the trader’s strategy, up-to-date information on correlation interaction, its trends and changes will provide powerful support in making decisions on diversification of reserves, search for alternatives and hedging, which will ultimately have a positive impact on income.