EUR/USD and USD/JPY 2002-2008: intermarket correlations (leader-follower)

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Written by Forex Automaton   
Thursday, 29 May 2008 15:07

Euro / US Dollar and US Dollar / Yen are obviously anticorrelated currency pairs. But, which one is the leader and which one is the follower? How long do the markets take to work out the anticorrelation? If the adjustment is not instantaneous, can one currency be used to predict the other?

Table: Pearson correlation coefficient for the time series of logarithmic returns in EUR/USD and USD/JPY in various trading sessions in 2002-2008.

time scale Asia-Pacific session European session American session
hour -0.40 -0.53 -0.55
EUR/USD and USD/JPY are, understandably, anticorrelated. What is not so obvious is the observation that the anticorrelation is the least pronounced in the Asia-Pacific session.

EUR/USD and USD/JPY intermarket correlation

Fig.1: Cross-correlation of EUR/USD and USD/JPY, derived from the hour-by-hour logarithmic returns, for the three trading sessions.

In Fig.1, there is one feature worth noticing: that is the bin with the time lag -1. It is negative but not as negative as the time lag 0. But while time lag 0 can not be used for prediction, time lag -1 (as any non-zero time lag) can. We define lag as time for the market 1 minus time for the market 2. In this case, time for EUR/USD minus time for USD/JPY. A positive correlation at a certain time lag tells you: "same thing happens in two markets with a certain time lag". A negative correlation at a certain time lag tells you "markets are doing the opposite thing with a certain time lag". The fact that most of the correlation is concentrated at the 0 lag means that the correlation (reported in the table) works out mostly on the time scale of up to 1 hour. The time bin to the left of the 0 lag indicates that there is a "tail" of predictable action lagging behind. Finally the most important thing: time lag -1 hour means that EUR/USD is leading and USD/JPY is following -- in the European and American but not the Asia-Pacific session.

EUR/USD and USD/JPY intermarket correlation compared with noise

Fig.2: Cross-correlation of EUR/USD and USD/JPY, derived from the hour-by-hour logarithmic returns, for the European (Eurasian) trading session shown against the backdrop of statistical noise (red). The noise is obtained from martingale simulations respecting the volatilities of EUR/USD and USD/JPY in this particular trading session.

As Fig.2 demonstrates, the main challenge while working with trading session-specific correlations is the non-linear (although quite predictable) behaviour of the noise level with time lag. This can not be ignored otherwise one risks over-interpreting the picture. The area around zero is fairly safe since the noise is at the minimum when the lag is at an integer number of days. The conclusion about the leader and follower currency pair, drawn on the basis of the asymmetry of the central peak, is significant despite the noise. For trading EUR/USD and USD/JPY on the basis of the intermarket correlation strategy, European and American trading sessions are the best time.

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