By Stephen McMannis, University of Pittsburgh
If you are involved in the markets at all or watch any financial news network like CNBC or Bloomberg then you would be familiar with the word correlation. Guests will get on and drop the term usually in reference to dollar and commodities (oil, gold, silver). For example, in historical terms any dollar strength results in commodity price weakness and vice versa. However, this does not always hold true as correlation varies continuously; and what hold true today does not always hold true tomorrow.
Apart from the previous relationship we discussed, the foreign exchange market is full of correlations across all the currency pairs that exist. For those new to the FX market the primary pairs that are traded (referred to as the majors) include EUR/USD, USD/JPY, GBP/USD, USD/CHF, and sometimes the USD/CAD and AUD/USD. One key point to take note of is that all the pairs whether it’s the Pound or the Canadian dollar - is tied to the US dollar. And in that same manner they are all related no matter which country of origin because they are tied to the dollar. So, for example if the dollar is weak on a particular day then all the other currencies should theoretically gain strength.
Going back at correlation it is defined roughly as the statistical measure of the relationship between two instruments. Well, in the foreign exchange markets there are long periods in which major pairs all could move in the same direction and can be considered “positively correlated”. Recently there was large talk of the dollar carry trade which was when it was cheaper to borrow dollars and then purchase higher yielding assets in foreign currencies with those dollars. The result was downward pressure on the dollar and at the same time upward force on currencies like the Euro and Australian Dollar. During this time the correlations reached near +1 which means they were again positively correlated; and in the cases of EUR/USD compared with the USD/CHF, -1 (negatively correlated).
Now that we know that pairs can often move in the same direction there are two options; we manage the risk associated across multiple pairs or even leverage that. In the first instance we can place opposite positions in 2 highly positively correlated pairs with the hope to hedge any movements of the two. Let me be clear and state that a perfect hedge never exists and doing so will raise transaction costs. Let’s look at an example: perhaps we made a directional trade by going long the EUR/USD dollar pair at 1.34 which then moves to 1.35 (resulting in a gain of 100 pips). We would like to lock in this profit without losing our long Euro position so we would need to look at a short term correlation like 1 day and then pick the pair closest to +1. As a result we would open an equal size position SHORT say the AUD/USD (buying US Dollars and selling Australian Dollars). Assuming no over performance by the Australian dollar we could have almost a hedged position in direction. Yet, this is not perfect because daily movements in both pairs equal different amounts of pips.
Also, another risk is that a portfolio is susceptible to is you may be long USD/CAD and the USD/JPY; the pairs are highly positively correlated. Well then, you essentially are long twice as much as you had intended in a US dollar position. On the other hand say these two pairs are negatively correlated – near -1 then you essentially have no position.
Both aspects are critical to understanding risk management of foreign exchange trading and understanding moves within the market. For those looking to experiment more with this concept a free correlation matrix is available online at http://www.mataf.net/en/tools/correlation. Also, many strategies can be developed to both optimize a portfolio and also minimize market exposure based on these correlations.
