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Correlation in Forex: Is the $Usa Correlated with World Bourses?
Is The $US Correlated to World Bourses & If So How? This very detailed piece of research & subsequent article is an entry from Miles B for the summer competition. There is also attached at the end an excel sheet for all the statistics for those with a mathematical/statistical mind.
I know that Viktor & John D amongst others follow this correlation & we have other mathematicians including Irina & Mary so I think this should certainly be the starting point to develop this further within the forum.
On to the Article:
I read or heard somewhere that the USD is negatively correlated to the stock market, so in the hope of winning the big prize of lifetime membership, I set about researching the relationship between the USD and the stock exchange that I more narrowly defined to be Standard & Poor’s 500 index (S&P 500).
Having shown that there is a relationship between USD and Standard & Poor’s 500 (S&P 500), I then showed that there is a strong relationship between S&P 500 index and the FTSE 100, CAC 40, DAX and Nikkei.
Conclusion
The USD is statistically significantly negatively correlated to the S&P 500. For every 1% change in the S&P 500 the USD changes by 0.32% in the opposite direction. i.e. increase in S&P 500 of 10% is generally matched by a decrease in the value of USD by about 3.2%. Furthermore, the FTSE 100, CAC 40, DAX and Nikkei bourses are statistically significantly correlated to the S&P 500.
We should therefore take into account how any one or more of these stock markets are moving when we are planning a trade as part of our assessment of the likely direction of travel for the USD.
The hypothesis
The hypothesis that I set out to test is that the rise and fall of the S&P 500 is a proxy for worldwide economic confidence and that when confidence is low the market falls and the USD rises. When confidence is high the market rises and USD falls. Why should this be the case? When people are upbeat they buy the market of risky assets and other currencies by selling USD. This causes USD to fall as the market rises.
Conversely, when the market is spooked by bad news people sell risky assets and other currencies to buy USD that is considered a safe haven. This causes USD to rise and the markets to fall.
Note that this hypothesis is the exact opposite of what we expect to occur with all currencies other than USD. With every currency other than USD, we expect uncertainty or bad economic data for that country to result in a fall in the currency’s value.
The reason for the USD behaving in exactly the opposite way to all the other currencies is because it is the most traded currency in the world and it is the currency of the largest economy in the world. For both these reasons, USD is considered to be a safe haven.
Research methodology:
I took weekday closing prices from 2003 to date for USD versus JPY, CHF, CAD, EUR and AUD. I indexed each of the prices with 3rd April 2003 equalling 100. I then did a simple arithmetic average of the indices for each day that gave a USD average index (with 3rd April 2003 being 100). The USD average index was then charted alongside the S&P 500 index that I had restated with 3rd April 2003 also equalling 100.
The chart below shows that as the S&P 500 index rose, the USD index fell and when the S&P index fell the USD index rose. I consider the S&P index as a proxy for worldwide economic confidence and that when the index is rising people are more confident and sell dollars to buy other riskier assets (see 2003-7 and 2009-10). Conversely when the S&P 500 is falling people worldwide become risk-averse and sell assets to hold onto dollars so USD rises when S&P 500 falls (see 2007-9).
Time constraints meant that I took a shorter data series to compare the movement of FTSE 100, DAX, CAC 40 and Nikkei against the S&P 500. The data series spanned weekdays from 16th April 2008 to 4th June 2010. The hypothesis to be tested is that these major bourses move in step with S&P 500. I found that this was indeed the case as detailed below:
Correlation April 2008 to June 2010 Percentage
FTSE 100 and S&P 500 index 95.54%
CAC 40 and S&P 500 index 97.77%
DAX and S&P 500 index 98.69%
Nikkei and S&P 500 index 94.43%
The correlations above, being close to 100% indicate that there is a very strong positive relationship between each of the bourses and the S&P 500. The bourses move in step with each other meaning that the relationship between the price of USD and S&P 500 can be generalised to exist with these other bourses too.
This means that we can watch the movement of these bourses to provide clues, even when New York (S&P 500) is closed.
The maths:
It turns out that over the past seven years the USD was indeed negatively correlated to the S&P 500 with a correlation of just under negative 43%. In other words, approximately 43% of the change in the value of the USD against other currency pairs is correlated to the change in S&P 500 index meaning that 57% of the change in USD value was due to other factors. That’s quite good but not quite good enough...
However...
From To Correlation
April 2003 March 2004 -91.3%
April 2004 March 2005 -86.1%
April 2008 March 2009 -96.3%
April 2009 March 2010 -82.4%
Now that’s more like it. This means that we should be watching the S&P 500 or one of the other exchanges listed above to give clues of how weak or strong the USD will likely be.
But...
From To Correlation
April 2005 March 2006 +68.5%
April 2006 March 2007 -31.4%
April 2007 March 2008 +64.7%
Oh dear back to the drawing board.
2005-6 and 2007-8 were positively correlated – entirely the wrong relationship from the one described above and 2006-7 whilst negatively correlated was pretty weak at just 31%. Clearly from 2005 to 2007 there were a lot of other factors at work causing the dollar to move against other currencies as it did.
Notably 2005-7 was a time of extraordinarily loose monetary policy throughout the world leading to the credit crunch of 2008. I think that could well be the explanation.
How much does USD move for every 1 percent change in S&P 500? The USD changes value by a little under 1/3 percent in the opposite direction. Therefore if the S&P 500 rises by 10% USD falls against other currencies by 3.2%. Please see the chart below for the period 1st March 2010 to 25th June 2010.
The chart above shows the value of USD index up the vertical axis plotted against the same day’s S&P 500 index along the horizontal axis. The black line is the line of best fit (calculated by linear regression) and has a slope of -0.3176. This slope means that over this period on the average for every one percent change in the S&P 500 index the value of USD changed in the opposite direction by 0.32%.
This means that USD, being the world’s reserve currency and the currency of the world’s largest economy acts in an exactly opposite manner to that of any other currency. Other currencies go up on good news and down on bad news. Conversely, The USD loves bad economic news, and withers and wilts whenever the stock markets are thriving on good news.
Miles B 27th July 2010
Footnote from Marc Walton There is an excel workbook that includes all those dull mathematical bits and the charts. If you would like a copy then please send me a private message
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Fascinating...
Originally Posted by capsmart
