In order to be an effective trader, it is important to understand how
different currency pairs move in relation to each other. There are a few
reasons why this is significant, but most importantly, it allows traders to
understand their exposure. That is, having a portfolio that consists of
the EURUSD and USDCHF is different than having a portfolio comprised of EURUSD
and GBPUSD. As indicated in the tables below, over the past year,
EURUSD has had a strong negative correlation (-0.89) with USDCHF and a
relatively positive correlation to GBPUSD (+0.74). Therefore having long
EURUSD and long USDCHF exposure would generally negate profit or loss because
when EURUSD rallies, USDCHF will sell off the majority of the time. Of
course, these two currencies may have different pip values and the correlation
is not perfect, so the P/L may not be exactly zero. On the other hand, holding
long EURUSD and long GBPUSD exposures would be similar to nearly doubling up in
one of the pairs since the correlation is so strong. Furthermore, we can
tell from our tables that correlations shift with time. For example,
EURUSD held a relavant strong negative correlation to USDJPY (-0.46) over the
past year. However, just this past month, the relationship has completely
broken down (0.00). Shifts such as these can be partially explained by changes
in the severity of monetary policy or changes in unique domestic
conditions. Overall, having this knowledge will allow traders to
effectively diversify and manage their portfolios.
Regardless of your trading strategy and whether you are looking to diversify your positions or find alternate pairs to leverage your view, it is very important to keep in mind the correlation between various currency pairs and their shifting trends.
FX Correlations (data as of 07/02/07)
