Correlation

How currencies move in relation to each other often has a serious effect on the risk being run in a currency portfolio.

The risk in running a portfolio that consists of Usd/Chf and Eur/Usd is very different to a portfolio of Usd/Chf and Usd/Jpy. Being aware of how correlated these currency pairs has a major effect on the profitability of a portfolio.

On this example, Usd/Chf if heavily correlated with Eur/Usd. So if one is long both these pairs a rally in Eur/Usd would generally mean a fall in Usd/Chf thus negating profitability.

However, being long both Usd/chf and Usd/Jpy is merely doubling up the position as these two pairs have very high positive correlation which means they virtually run in tandem.

Correlation or how correlated currency pairs are shifts all the time so there is no hard and fast rule. Regardless of your trading strategy or whether you wish to add or pare back risk it is important to look at historical correlations and try to tie them back to individual events.

As part of your overall strategy you will be far more successful if you understand all the relationships that drive markets and correlation is one of the major factors.