GBP/USD and USD/JPY 2002-2008: hints of predictive correlations

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Written by Forex Automaton   
Wednesday, 10 September 2008 14:00

The case of Pound Sterling/US Dollar and US Dollar/ Japanese Yen shows hints of predictability in the latter rate on the basis of the former on average for the period. This may indicate that stronger signals might exist at particular time intervals or on shorter time scales, but get watered down in the time average. A candidate for a deeper study.

GBP/USD and USD/JPY volatility comparison

Fig.1: comparing volatilities of hour-by-hour logarithmic returns in GBP/USD (top panel) and USD/JPY (bottom panel) for the three trading sessions: Asia-Pacific session, European session, and the American session. The sessions are defined in New York time to be at least 12 hour long each. The histograms are normalized distributions of logarithmic returns.

Table 1: Hour-by-hour volatilities (RMS) for the time series of logarithmic returns in GBP/USD and USD/JPY in various trading sessions in 2002-2008.

currency pair time scale Asia-Pacific session European session American session
GBP/USD hour 0.94×10-3 1.2×10-3 1.1×10-3
USD/JPY hour 1.1×10-3 1.3×10-3 1.2×10-3

Fig.1 and Table 1 show that the volatilities of GBP/USD and USD/JPY are similar. The Asia-Pacific session is the least volatile with these exchange rates as it frequently is. As always in forex, at least on the 1-hour time scale considered, the distributions of logarithmic returns are not "bell-shaped", they are strongly non-Gaussian. The distributions look roughly triangular on the log scale. Therefore a lot more appropriate model for the tails would be an exponent, meaning the returns themselves (not the logarithms) follow a power law. An option buyer armed with the right pricing formula could capitalize on the fat tails (provided that the tails persist on the time scale of interest to such a trader) but one would not be able to make forecasts based on Fig.1.

Table 2: Pearson correlation coefficient for the time series of logarithmic returns in GBP/USD and USD/JPY 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 -0.30 -0.42 -0.46

GBP/USD and USD/JPY are negatively correlated on average for the period, throughout the three trading sessions studied. The Asia-Pacific session, the least volatile for both rates, is also the one with the lowest correlation (by absolute value).

GBP/USD and USD/JPY intermarket correlation 1 hour time-lag bin

Fig.2: Cross-correlation of GBP/USD and USD/JPY, derived from the hour-by-hour logarithmic returns, for the three trading sessions. Time frames of the sessions are shown in New York time.

Fig.2 presents the cross-correlation of GBP/USD and USD/JPY over the time lag (hours). 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, correlation amplitudes at non-zero time lags would be of particular importance. The correlation value at the -1 hour time lag, just to the left of the middle negative peak, looks like a residual of a correlation tail extending into the area of negative time lags. (Time lags are defined as

t1-t2

where "1" denotes GBP/USD and "2"-- USD/JPY. Thus, a negative correlation value at a negative time lag means that statistically there is a tendency for exchange rate "2" to do the opposite to exchange rate "1" at a later time.) A comparison with the same analysis performed repeatedly on the random data designed to mimic volatilities of GBP/USD and USD/JPY lets one estimate the accuracy of the correlation measurements and thus the potential value of these for any hypothetical trading strategy based on intermarket correlations. Such a comparison is presented in Fig.3 below.

GBP/USD and USD/JPY intermarket correlation 1 hour time-lag bin with uncertainty estimate

Fig.3: Cross-correlation of GBP/USD and USD/JPY 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 GBP/USD and USD/JPY in this trading session for the period under study. The noise is presented as mean plus-minus 1 RMS, where RMS characterizes the distribution of the correlation value obtained for each particular bin by analyzing 20 independent simulated pairs of uncorrelated time series.

Fig.3 demonstrates the non-flat (although quite predictable) behaviour of the noise level with time lag, caused by the constraint on the time lags associated with the definition of the trading session time window. 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. Naturally, as the random model responsible for the noise (red background in the figure) does not contain any correlation between the two exchange rates, it shows no correlation peak at the zero time lag. As the comparison with noise indicates, the couple of correlation values that look like the end of a correlation tail at the negative time lags are in fact merely 2-3 standard deviations above the reference (uncorrelated time series with the volatilities of the real ones).

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

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