Currency correlation is nothing but the interdependence between currencies and currency pairs. If you were trading GBP/AUD, you can guess that value of this currency pair might be related to the value of GBP/USD and USD/AUD pairs. While in some case price of one currency pair moves in the same direction as that of another, in some other cases prices might move in opposite directions as well. Thus correlation is nothing but the measure of the relationship between two currency pairs.
Correlation Coefficient is the term which refers to the statistical measure of interdependence between two currency pairs. Correlation coefficient can have a value between -1 and +1. A value of +1 indicates that the two currency pairs will move in the same direction always. A correlation of -1 indicates that the two currency pairs always move in the opposite directions. And a value of 0 indicates that it can be either ways or the direction of movement is random. Always bear in mind that correlation does not remain stable and it can change.
Forex traders trade multiple currency pairs simultaneously and hence it is very important to understand the level of interdependence between them. When a trader optimizes his or her portfolio, there are high chances that he or she might increase the risk, in case the measure of correlation is not figured out. Correlations are calculated for multiple time frames to give the traders a clear cut view on the direction of price movements.
A table named Currency Correlation Table is used to represent correlation data for various time periods. Correlation data is colour coded to help traders easily understand the currency correlations within the large set of data.
In addition to understanding how currencies are interrelated to one another, it is equally important to know how Forex market relates to other financial markets. We will explain it through couple of examples below.
Indexes and Currencies
The US Dollar index (USDX) provides a view of the movement of US Dollar in the financial market. It is an indication of the value of US Dollar. There is thus strong correlation between US Dollar index and currency pairs traded in the Forex Market. Similarly the Stock indexes and stock markets are correlated to the Forex Currency pairs.
Gold and Currencies
Gold was treated as a replacement to currency from long time back. Price of Gold affects the Forex market. There is thus a strong correlation between gold and currencies. For example, it can be seen that when USD rises, gold prices fall too and vice versa.
Similarly there are correlations between oil and currency pairs. So as a trader you need to be aware of these inter-market correlations (between Forex and other markets) as well in addition to the intra market correlations (between currencies).
To be a successful trader it is important to how different currencies move in relation to each other. Currency correlations can be very useful tool to understand which currency pairs go hand in hand and which don’t. This can be very helpful for the traders to organize their portfolio. They can identify which currency pairs can be used to hedge their risk due to exposure from another currency pair.