AUD/USD and USD/CAD 2002-2008: intermarket correlations (leader-follower)

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Written by Forex Automaton   
Monday, 23 June 2008 16:11

Australian Dollar/US Dollar and US Dollar/Canadian Dollar are, of course, negatively correlated currency pairs. Based on the asymmetric shape of the correlation peak, it is safer to bet on AUD/USD leading and CAD/USD following, although it is possible that CAD/USD leads and AUD/USD follows.

Table: Pearson correlation coefficient for the time series of logarithmic returns in AUD/USD and USD/CAD in various trading sessions in 2002-2008. Time frames of the sessions are shown in New York time.

time scale Asia-Pacific session European session American session
hour -0.37 -0.44 -0.44

AUD/USD and USD/CAD are negatively correlated on average for the period, therefore sometimes to simplify the language we will talk about AUD/USD and CAD/USD being correlated. Looking at the 0-hour time lag, which is what the table represents, the correlation is the least pronounced in the Asia-Pacific session, most pronounced in the European and American session.

AUD/USD and USD/CAD intermarket correlation 1 hour time-lag bin

Fig.1: Cross-correlation of AUD/USD and USD/CAD, derived from the hour-by-hour logarithmic returns, for the three trading sessions. Time frames of the sessions are shown in New York time.

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. For the purpose of forex trading system development, correlations with non-zero time lag are of particular importance. It is these correlations that allow us to make forecasts, and they are visible in the figure: the peak around the 0 time lag bin is definitely more than one bin wide. This statement is quantified and supported by comparison with statistical noise in Fig.2.

AUD/USD and USD/CAD intermarket correlation 1 hour time-lag bin with uncertainty estimate

Fig.2: Cross-correlation of AUD/USD and USD/CAD for the European (Eurasian) trading session shown against the backdrop of statistical noise (red). The noise is obtained from martingale simulations based on the recorded volatilities of AUD/USD and USD/CAD in this trading session for the period under study. The noise is presented as mean plus-minus 1 RMS, where the RMS characterizes the distribution of the correlation value obtained for each particular bin by analyzing 20 independent simulated pairs of uncorrelated time series.

We inspect significance of the predictive correlation in the AUD/USD and USD/CAD exchange rate by comparing with the expected statistical fluctuations (noise) in Fig.2, as explained in the figure caption. The signal in the -1 hour time lag bin looks quote comfortably significant. In our convention, the time lag is

t1-t2

where "1" denotes AUD/USD and "2" denotes USD/CAD.

Therfore, the interpretation of the central peak signal along with the -1 hour time lag bin is as follows: AUD/USD leads and CAD/USD follows in the same direction within 0 to 2 hours. Again we see a pair with the stronger interest rate differential show the way to a pair with a weaker interest rate differential, despite the fact the AUD represents a somewhat smaller economy compared to Canada. Likewise, in the AUD/JPY and EUR/USD analysis we see that it is the AUD/JPY who leads, because of the greater interest rate differential and despite the the fact the EUR represents the far greater economic power of the European Union.

The data used are from the period 2002-08-20 00:00:00 to 2008-02-01 00:00:00.

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