Currency correlation, forex correlations, currency pairs correlation

Over the last few years, the relationship between the various financial markets has become increasingly close. The behavior of the most important currency pairs influences directly and immediately both the equity markets and those bonds. Financial markets can be found in two different situations:

  • A first condition, so to speak “normal” (defined “Risk on“), has no special tensions and is characterized by a certain risk appetite. Business investors are looking for high returns.The liquidity moves to more aggressive currencies that offer a higher interest rate and that are related to the behavior of raw materials. In this phase, the New Zealand dollarthe Australian dollar and the Canadian dollar usually tend to appreciate themselves.
  • The second condition, called “Risk off“, is instead characterized by tensions and uncertainties. During this phase there is the phenomenon of so-called “flight to quality”, i.e. a shift of liquidity to tasks with a low risk profile. The market leaves the aggressive currencies, and moves towards those considered to be safer as the Swiss franc.

Of the approximately 4 billion dollars which are traded every day on the Forex, the currency pair EUR / USD is responsible for about 30% of the volumes traded. For this reason it is the most liquid pair in the world. The daily volatility is usually very high.

The euro tends to be positively correlated with financial assets that are in turn negatively correlated with the dollar. In particular, a strengthening of the euro promotes a positive trend in equity markets, while an excessive strengthening of the dollar triggers a negative trend of these markets.

Before 2008 there was a very close relationship between the performance of the dollar and the gold. When the first was strengthened, the second was weakened and vice versa. The correlation disappeared during these years of economic crisis, since the main variable followed by the market was the risk aversion. In general, you can note that the currency pair EUR / USD is negatively correlated with the pair USD / CHF and positively correlated with the pair GBP / USD.
The currency pair GBP / USD, known as “cable”, is one of the major pairs of the currency market because of the strong financial ties between Great Britain and the United States. The cable is a volatile pair. For this reason, when operating on this pair, it is desirable to widen the stop loss, because the sudden oscillations of some tens of pips are very frequent. London is the seat of the major global banks. In the capital you will find most of the market makers and dealer banks, mainly responsible for transactions on the pair GBP / USD. This implies that these operators have a good view of the positions and stop loss of their customers. They are famous for being real “hunters stop loss”.

The pound is very sensitive to the price of oil and energy in general, since the production of the latter is responsible for about 10% of English GDP. For this reason, an increase in the price of oil can result in a strengthening of the currency, a fall in price can lead to a weakening of the currency.

Given the importance of trade relations that exist between the United States and Japan, the pair USD / GPY is very important, because it is the reference for all the currency pairs that include the yen. It is the pair on which, with some frequency, the central banks make direct interventions (especially the Japanese one). The BOJ (Bank of Japan) intervenes by selling yen and buying dollars when the price of USD / GPY falls below certain critical thresholds. Japan, being a large exporter, especially of technological products, has an interest in keeping its currency weak, making a competitive devaluation. The importance of the EUR / GPY has increased considerably in recent years. It is a volatile pair, since it is characterized by an average daily range of about 200 pips. Because this currency pair is active during the European session, the prices are constantly moving throughout the day. In the European morning the EUR / GPY behaves in a regular way. In the afternoon, however, when the U.S. markets open, you experience frequent fluctuations.

Correlation measures the degree of dependence between two variables. Suppose that X and Y are random variables with medium E (X), E (Y) and variance var (X), var (Y).

The covariance (COV) of X and Y is defined as follows: cov (X, Y) = E {[XE (X)] [YE (Y)]}.
The correlation of X and Y is defined as follows: cor (X, Y) = cov (X, Y) / [sd (X) * sd (Y)].
You may encounter three different situations:

  • When the sign is positive, the variables are said to be positively correlated.
  • When the sign is negative, the variables are said to be negatively correlated.
  • Where the sign is in a neighborhood of zero, the variables are said not to be related.

Therefore the correlation measures the relationship between two variables:

  • The value +1 (the maximum) indicates that the two variables move in the same direction in 100% of cases.
  • The value -1 (the minimum) indicates that the two variables are moving in the opposite direction in 100% of cases.

The correlations change over the course of days and months.

The Author

Alberto Cannata

My name is Alberto Cannata and for some years I have dealt with Forex trading. I have a degree in computer science. Financial markets have always interested me, and especially the foreign exchange market. I started to read some books about forex in 2008 and I was immediately interested in this topic. I deepened my studies about technical analysis and the main trading platforms, to better understand the mechanisms that regulate the forex market. I decided to share my experience by publishing an online guide about forex, that I periodically update. You can find my guide at the following link: www.totradeforex.com
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