Forex Correlation (2)
As discussed in part 1, underlying any correlated pair of currencies, there is a correlating currency that correlate the two in the pair. An example used in part 1 is the pair GBPJPY and USDJPY. They are highly correlated, and the underlying correlating current is GBPUSD. Correlation investing strategy says that you can buy or sell GBPJP and USDJPY at the same time, and because of the high correlation, they move in the same direction until you get some “window of opportunity” when by some known or unknown market reasons, the prices diverge, and you can make a profit out it by entering or exiting your trade. We will try to examine how good correlation investing is (or is not).
We tried to use arbitage (GBPJPY/USDJPY) as a measure of divergence, but when we compared the arbitage with the underlying currency (i.e. we calculated the correlation between arbitage and GBPUSD), we found that using arbitage is basically the same as using the underlying currency, GBPUSD. There is really not much advantage, if at all, of using arbitage compared to using the correlating currency. Furthermore, there doesn’t seem to be much advantage of trading the correlated pairs (GBPJPY and USDJPY together) instead of trading in the correlating pair (GBPUSD).
In this article, we will examine other pairs and show the correlated between the arbitage and the correlating pair. It might be easier for you to follow this article if you first read part 1 of the article.
Without further delay, here is the table for some correlated pairs. Each row shows a correlated pairs. The first two columns are the pairs, and the 3rd column is the proposed underlying pair. Arbitage is defined as the ratio of the first pair to the second (e.g. AUDUSD/NZDUSD for the first row). The arbitage correlation is the correlation cofficient between arbitage and the underlying pair. We are trying to examine if arbitage is indeed related to the underlying pair (in a few cases it is not).
Arbitage Correlation Table
| currency 1 | currency 2 | underlying currency | arbitage correlation (daily) | arbitage correlation (hourly) | arbitage correlation (5-minute) |
|---|---|---|---|---|---|
| AUDUSD | NZDUSD | AUDNZD | 0.999867 | 0.998993 | 0.998166 |
| AUDUSD | USDCAD | AUDCAD | 0.999993 | 0.999978 | 0.999715 |
| EURUSD | AUDUSD | EURAUD | 0.999983 | 0.999847 | 0.999849 |
| EURUSD | USDCHF | EURCHF | 0.999992 | 0.999848 | 0.999551 |
| NZDUSD | USDCAD | NZDCAD | 0.999883 | 0.999672 | 0.999398 |
One adjustment has to be made on the calculation of arbitage. In a pair like EURUSD and USDCHF, since USD is on the opposite sides, arbitage is defined as be the product of EURUSD and USDCHF instead of the ratio. This is true for any pair that is correlated negatively.
As you can see from the table, all the correlations between arbitage and the underlying pair has coefficients greater than 0.999! That is almost perfect correlation. That means the divergence and convergence of the correlated pair are determined by the underlying currency.
Let’s take EURUSD and USDCHF as an example. The pair are correlating negatively. The movements are almost like mirror images of one another. That is pretty easy to understand. The movement is determined by the strength of US dollar. If USD is strengthening, then EURUSD will go down and USDCHF will go up. It is just as simple as that. If the value of Euros and Swiss Franc never change, the EURUSD and USDCHF will mirror one another perfectly (except in scale) depending on the strength of US dollar. However, the values of Euro and Franc will not stay still forever, so instead of perfect mirror effect, they will fluctuate, and you can see that fluctuation in EURCHF.
Since the fluctuation is in some way unpredictable, there is no way you can predict the divergence or convergence. If there is no sudden and drastic event happening, in the long run the correlated pair will correlate even after a period of divergence. But perhaps here is where the fallacy lies: correlated does not necessarily mean convergence! For a positively correlated pair, most of the time they move in the same direction. Occasionally they might move in the opposite direction so that their “gap” closes, and after a while they might move back in the same direction, but that does not mean that the gap will always open up again.
In other words, you can buy EURUSD and USDCHF simultaneously to form a hedged pair, but you do not know when the pair is going to “open up” or “close down” in prices. You can use EURCHF as a helper, but the predictability of EURCHF is just like any other currency. You can never tell for sure. As pointed out in part 1 and can be seen in the coefficients above, trading in correlated pair like this is basically the same as trading in EURCHF.
In the next article I will show examples from real charts to hopefully make things clearer.