Learning

Jul 4

# What is currency correlation?

Currency correlation shows traders whether two currency pairs move in the same, opposite, or completely random direction over time. For example, if you trade the British pound and the Japanese yen (GBP/JPY), you are actually trading one of the branches of the GBP/USD and USD/JPY pairs . These currencies are correlated because they are both linked to the USD.

If you express the correlation numerically, it is expressed through a special coefficient:

• +1 suggests that the two FX pairs will move in the same direction 100% of the time;
• -1 implies that the two FX pairs will move in opposite directions 100% of the time;
• 0 indicates no correlation between the two currency pairs.

There are two types of correlations: positive and negative.

Example of positive (direct) correlation: the chart shows EUR/USD and GBP/USD.

Example of negative (inverse) correlation: The chart shows the DXY and EURO futures.

As a rule, the correlation between the instruments is displayed in the form of a table:

Currency correlation is volatile, so it is worth periodically adjusting it. There are several reasons why the correlation coefficient changes. The most popular ones are the different monetary policies, the reaction of currency pairs to changes in the value of commodities, as well as changes in fundamental factors.

Today, there are many technical indicators and algorithms for Meta Trader platforms that help monitor the correlation between instruments. But every trader can independently count the correlation between instruments in an Excel spreadsheet through the function “=CORREL(range1, range2)”.

Traders usually use currency correlation for different trading strategies, position hedging, and risk diversification.

The most popular correlations on the currency market:

• The euro has an inverse correlation to the dollar index (a fall in the dollar leads to a rise in the euro and vice versa);
• The Canadian dollar has a direct correlation to oil (the growth of oil prices provokes the strengthening of the Canadian dollar and vice versa);
• The Australian dollar is directly correlated with gold (the growth of precious metal prices equals the growth of AUD and vice versa);
• Gold is inversely correlated to the dollar index and government bond yields (a drop in the dollar and government bond yields leads to higher prices of precious metals, and vice versa).