## Introducing CERCSI, the correlation-based forex correlation strength index

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 Written by Forex Automaton Saturday, 24 March 2012 11:16 Currency Exchange Rate Correlation Strength Index (CERCSI) is a measure of zero-lag correlation strength with a specified timeframe (time scale) and measurement interval. For quantities we report regularly, measurement interval is the same as period of measurement. The quantities reported in the Forex Correlation Analysis Reports 1H.1M section of the site are measured monthly at the end of a month and include the whole month of data. This article defines the way CERCSI is constructed.   ForexAutomaton follows the convention whereby time scale and period of measurement enter the name of the quantity being reported in the time scale.time interval. For example, quantities reported in the Forex Correlation Analysis Reports 1H.1M are 1H.1M quantities, having time scale of one hour (1H) and period of measurement one month (1M). CERCSI is constructed from zero time lag intermarket correlation coefficients among 14 most popular foreign exchange rates: AUD/JPY, AUD/USD, CHF/JPY, EUR/AUD, EUR/CHF, EUR/GBP, EUR/JPY, EUR/USD, GBP/CHF, GBP/JPY, GBP/USD, USD/CAD, USD/CHF, USD/JPY. The 14 currency pairs form 14×(14-1)/2 = 91 unique combinations, and for each of these, a correlation function is constructed and analyzed. In constructing CERCSI, as elsewhere in the ForexAutomaton project, logarithmic returns rather than actual price quotes are used. CERCSI is defined as the average of the 91 above-described coefficients, each of which is taken by modulus or absolute value: CERCSI = Sumdifferent i,j|C(1|xi,xj)| /Sumdifferent i,j 1 = Sumdifferent i,j |P[xi(t),xj(t)]over an interval of t|/Sumdifferent i,j1, where P[xi(t),xj(t)]over an interval of t is the Pearson correlation coefficient between the two time series. Bouts of panic in the markets, such as seen in Fall 2008, during the "Flash Crash" of 2010, or after the US credit rating downgrade in 2011, are characterized not only by high volatility, but also by unusually high degree of correlation among the instruments. The concept of portfolio diversification collapses, as the universe of financial instruments degenerates into risky assets and safe haven assets. Mathematically, this degeneration does not follow from a rise in volatility, and represents an independent quantitative aspect of the panic phenomenon. Being independent of volatility by construction, CERCSI is designed to isolate and monitor this particular aspect.