Written by: PaxForex analytics dept - Friday, 27 June 2014 1 comments
Some currency pairs often move in one direction. Others - in opposite directions. The relationship of movement of different tools can be used for certain purposes in forex trading. For example, the correlation can be used to diversify Forex portfolio and risks. The correlation is also used to hedge positions.
The correlation of the currency pairs shows how unidirectional (or multidirectional) they moved in the past, statistically. The correlation coefficient, a number between -1 and 1, indicates how much foreign currency instruments are correlated with each other. For example, if the correlation coefficient of pairs GBP / USD and EUR / USD is over 0.80, then we say that these pairs are highly correlated: if the GBP / USD goes up, then the EUR / USD, probably will go there too.
Therefore, the opening of an additional position for another correlating pair will increase riscs and will have a negative impact on Forex investor’s portfolio. On the other hand, the correlation coefficient of pairs EUR / USD and USD / CHF, may amount to -0.80, which means that, if the EUR /
USD will go up, then the pair USD / CHF, rather, will go down. So the deal to increase to USD / CHF can be used to hedge a long position in EUR / USD. If the correlation coefficient of two pairs of near 0, it is likely they will move independently of each other.
We must also remember that the correlation coefficient of the currency pairs may change over time - due to changes in monetary policy or changes in the country's economic and political spheres. For example, an agreement on extensive trade ties between the two countries could lead to the fact that these countries' currencies in the future will correlate very strongly.