In order to be an effective trader, it is also important to understand how different currency pairs move in relation to each other. There are a few reasons why this is significant, but most importantly, it allows traders to understand their exposure. That is, having a portfolio that consists of the EURUSD and AUDUSD is different from having a portfolio that consists of the EURUSD and USDCHF. As indicated in the tables below, over the past year, the EURUSD has had a strong positive correlation (+0.91) with the AUDUSD and a strongly negative correlation with USDCHF (-0.98). Therefore having a long EURUSD and long USDCHF exposure would generally lead to negated or nearly zero profit or losses because when the EURUSD rallies, USDCHF will sell off the majority of the time. Of course, these two currencies have different pip values, so the P/L may not be exactly zero. On the other hand, holding long EURUSD and long AUDUSD exposure is similar to doubling up on the position since the correlation is so strong. Furthermore, we can tell from our tables that correlations shift with time. Although the NZD/USD and USD/JPY usually have a very strong negative correlation, this was not evident in the 6 month correlation of 0.00. Having this knowledge will allow traders to effectively diversify and manage their portfolios. Shifts such as these can be partially explained by changes in the severity of monetary policy or changes in unique domestic conditions.

Regardless of your trading strategy and whether you are looking to diversify your positions or find alternate pairs to leverage your view, it is very important to keep in mind the correlation between various currency pairs and their shifting trends.

FX Correlations (data as of 05/31/05)