Forex markets are intricately-woven reflections of the supply and demand for currencies around the world. Whilst currencies are always quoted in pairs, as an explanation of the relative value of one against the other, they are all interlinked in varying degrees to all other pair’s movements and value. The relationship between these currency pairs is known as their ‘correlation’, or the degree to which the movements of one pair affects the movements of another. Correlations can change over time, with some pairs becoming more or less correlated with one another; however, many currency pairs have a consistent correlation which is important for forex traders who can use these to manage the exposure of their trades and in order to hedge their positions.
Understanding the degree to which currency pairs can be correlated removes counterproductive trading and the risk of two trades cancelling one another out. Correlation values are presented between -1 and +1 with a perfect correlation being +1 and no correlation being -1. These correlations are presented in a table which commonly provide the figures for one month and up to one year. It is important to remember that forex correlations are not necessarily fixed and are subject to fluctuations throughout the year and even on a daily basis. These changes underline the importance of checking currency correlations using longer term averages such as the yearly figure, in order to get a more comprehensive overview of the relationship between currency pairs.
Pairs that can be described as highly correlated, and therefore that move in unison, include the USD/GBP and GBP/JPY. The positive correlation between these pairs means that, when the USD/GBP rises or falls, it is very likely that the GBP/JPY will also follow this move. Entering opposing trades on both of these pairs, therefore, would be counterproductive as a long and short position on each of these would cancel one another out. Similarly, a currency pairs which have a high negative correlation, such as the EUR/USD and USD/CHF, will move in opposing directions most of the time. Taking a trade in the same direction on each of these pairs would therefore be likely to have the same negative effect of cancelling-out any gains.
Factors which influence the relationship between currency pairs can include geopolitical changes, commodity price fluctuations and, importantly, convergence and divergence of monetary policy. As interest rates and speculation surrounding these is a major driver of currency movements, these can potentially influence the correlation between pairs with similar or opposing interest rate forecasts.
The benefits of trading using currency correlations
Correlations can also benefit forex traders by allowing them to spread their risk over highly correlated currency pairs. Rather than entering a position on just one currency pair, a portfolio can be diversified between highly correlated pairs in order to lower the risk associated with over-exposure. This is most effective when currency pairs are highly, but not perfectly, correlated. An example may be a long position on both the EUR/USD and AUD/USD which have a generally high correlation. The trade here would assume a devaluing of the USD but by spreading the risk between the two pairs. The difference in monetary policies between the Australian and European Central Banks would also help protect the trade against the rise of the US dollar as they are unlikely to be affected equally and one may therefore absorb some of the negative impact of the rise.
Furthermore, those pairs with a strong negative correlation can be used to hedge against one another. Due to the fact that the number of points movement for the two currencies are unlikely to be equal, traders can take advantage of this by taking opposing positions in order to offset any losses should the trade fail to be profitable. Although this will result in lower profits, the use of negatively correlated pairs to insure losses are limited is a good example of the benefit of understanding currency correlations.
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