Types of currency correlations

Types of currency correlations

Forex

Currencies, as we all know, serve as a medium of exchange for goods and services both locally and internationally all around the globe. But every country has its own currency and so this begs the question, in what medium do we trade on, on the international market? The answer to this question is simple. Currency exchange. No single currency is ever isolated.They are paired. What this means is that, in order for someone with USD to trade in Europe, USD has to be converted into euro and that is represented as EUR/USD. For instance, a currency exchange quote of 1.1500 for the EUR/USD currency pair means that every 1 EURO is equivalent to 1.1500 USD.

Although on the forex market you are not buying commodities but currencies, the same principle apply. In order to buy a currency on the forex market, you need to have an amount equivalent to the currency you want to buy based on the current rate and vise versa when you are selling a currency. This is the idea behind currency pairing.

The classification of currency pairs

Opinions on the forex market about which currency pairs are major and which ones are minor are different but mostly, the classification is based on the liquidity of the pair. Liquidity refers to how fast an asset or a financial instrument can be bought or sold without affecting the price of the asset.

Major currency pair

A major is a currency pair that has the USD as one of its component. Examples being EUR/USD, GBP/USD, USD/JPY, USD/CHF, and AUD/USD.

Minor currency pair

Using the same logic, a minor currency pair does not have the USD as one of its component. Examples being EUR/AUD, GBP/JPY, EUR/JPY, GBP/AUD.

How currency pairs correlate with each other?

On the forex market, traders usually trade on different pairs of currencies. This is a great way to make huge profit and also diversify your risks. With this in mind, it is of great importance to understand that currency pairs correlate with each other.

One may ask, what are market correlations? It’s basically how different currency pairs interrelate with each other. Some currency pairs move in similar directions almost all the time and it’s called positive correlation. Whilst some currencies have the tendency to move in the opposite direction and this is called negative correlation.

Positive correlation

Currency pairs like GBP/USD, AUD/USD, and EUR/USD are positively correlated with each other as USD serves as the quote currency. Therefore any changes in the strength of the USD directly affect these currencies pairs as well.

Negative correlation

In the opposite manner, currency pairs like USD/CHF, USD/JPY, and USD/CAD are considered to be negatively correlated. It’s obvious to note that the base currency of these pairs is the USD ego any changes in the strength of the USD also directly affects the pair. So as an amateur, you should have an answer to the question “what are market correlations?”

In conclusion, different factors such as inflation rates,  interest rates, a country’s current account, government debt, recession in a country and many more are some of the factors that cause either a negative correlation or a positive correlation. So regardless of your level of experience in the forex market, these factors and many more need to be considered before making a decision to trade on any currency pair.