Why such strong correlation of pairs?

flotsom:

I hope you are correct that it's not just a lucky streak.
The unsettling Archie Karas story brings itself to bear for me here. He started with $50, turned it into $40 million in eight months, and he was back to sleeping in his car again (broke) just three weeks later:
http://pokerworks.com/poker-news/201...hie-karas.html

(Granted, it's not currency trading.)

Thanks for stopping the flood Timevalue.

Why was "Trade Weighted Index" even mentioned in this thread?
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I know your question was answered, but to go a step further into the mechanics, it's largely from Basket Orders.

some things just stick with me, and this thread was one of them and has been bothering me since i first read it. from what i have read a lot of the poor OP's time was wasted being lead down the garden path, like usual on forums.

trade weighted index.... wtf? if my minimal googling has educated me enough on this subject then this answer is absolute crap to the highest degree! if i'm correct the trade weighted index is derived from the currency rates. it was said, or implied, that it was the other way around and currency rates are derived from this index. so wrong.

it's like any other 'index' on any exchange. it's one value to generalize the multitude of values within the exchange to give a broad view on the inner workings. share prices aren't derived from the s&p500 are they? of course not! that's stupid to even suggest! the s&p500 is derived from the top 500 performing symbols on the exchange (or something to that effect. i'm not particularly familiar with the specifics of this s&p index).

so, forget trade weighted index. that was a waste of everyone's time.

so how do you answer your question? like all other problems you try and reduce it to it's simplest form. in my mind this complex problem can be reduced to a simple imaginary situation...

imagine you have a bunch of bowls on a table. within each bowl is one type of currency. one bowl has euro's, one has aussie dollars, another has american dollars, another has pounds, another dmarks, etc etc. you can make it as complex or as simple as you like by adding or subtracting currencies (but no less than 3 else the example becomes pointless).

let's keep it simple. there are 3 bowls. euros, american dollars, and british pounds. they all have an equal amount of their respective currency in their bowls. you have in your hand a stash of euros. you go to the euro bowl and place it all in that bowl and then take an equivalent amount of GBP's from the GBP bowl.

if you stop and have a look at the bowls you will realize that all of a sudden there is an imbalance between all 3 bowls. there are more euros than any other currency, less gbp's than any other currency, and the usd are in the middle of the two. it stands to reason that since there are so few gbp's available that they are now a rarity and if you want to take any gbp's it will cost you more of the other currencies to be able to take any gbp's. like anything that becomes scarce the cost of buying these increases. the rarer something gets the more expensive it gets. in contrast, the more available something is the cheaper it becomes.

in this instance the euro's are aplenty and therefore aren't particularly worth that much, but the gbp's are rare and cost much more than either the euro's or usd's.

now you decide you are going to spend some of your gbp's to buy some usd's. since gbp's are rarer than the usd's you will get more usd's per gbp.

you can keep swapping in and out different amounts of money from the bowls.... you take a bit from one with the currency you have on hand, then you use this to buy some of the other currency, and round and round you go. the balance of rarity to abundant for each currency changes as you change the balance around with the continual exchanging of one currency for another.

so after this example what does it mean when you make gbp's rare by buying them with euro's like at the very start of this example? it means that the cost of gbp's in terms of euro's has increased. similarly, the cost of gbp's in terms of usd's has also increased. the usd's had no part in this exchange and was simply sitting on the sideline minding it's own business, but due to the change of balance between gbp's and euro's the usd relationship between the other 2 currencies has also shifted.

there's your correlation.

now this was a shitty and simplistic example. much more realistic is if you took those 3 bowls and added a whole lot of other bowls as well containing other currencies... then consider the whole mountain of bowls as actually being a bank. then, you have to imagine that there are other similar banks with stashes of different currencies.

finally, you need to understand that each bank won't actually have equal amounts of different currencies compared to all other banks, but the interrelationship between all banks as they go about swapping one currency for another creates the natural market mechanic of creating a balance point where there is an agreed and implied correct price of one currency versus another. if one bank happens to be quoting something noticeably different to all other banks then someone somewhere will be smart enough to quickly buy or sell the out-of-balance currency from this bank, and then offload it to one of the other banks who are all otherwise in agreement with what the price should be..... this is arbitrage. finding a misquote somewhere and taking advantage of the fact that this singular error stands alone against the horde of others who all stand in solidarity and agreement. much like a school of fish swimming together they all swim individually but overall all maintain a solidarity, and any fish that happens to stray from the overall movement of the pack is easy picking for predators.

the interbank relationship is obviously much more complex than this, but i imagine this is well-enough to paint a picture.

hopefully this wasn't all a total load of crap as well. if it is i hope someone comes along and corrects it.

Wow! What an amazing man. Don't know if I should, but I hold huge respect for him if the story is true.

nubcake, thank you for coming back to this thread and attempting to answer my question. It's nice to see someone on the forum attempt to highlight why other answer's are wrong, and to offer an alternative instead of merely coming in and informing everyone that previous answers are bollocks without explaining why. Thank you.

With more research, I am slowly coming to a clearer understanding in my own head about the almost immediate term correlation between currency quotes on pairs which at first glance are unrelated to each other.

My question may have seemed overly simplistic to many people, hence the reason for so many vague and simplistic answers which didn't really address my concern.

The trade weighted index is not the answer to the question, although I'm sure something similar is used by dealers (banks) to determine their quotes. My understanding is that the vast majority of the huge volume transacted in the forex market is due to dealers trading with other dealers, back and forth and round in circles in quick succession in order to gauge where each other is in terms of their estimate of true value. In an opaque market like forex, this is one of the only ways for each dealer to truly be able to accurately quote in line with the other dealers and remain competitive and profitable.

Logic would suggest to me that if a large transaction takes place with one dealer in one currency pair, as the other dealers are constantly asking for quotes from each other, they all see the large change in the first dealers quoted bid and offer and adjust their own accordingly for that pair. As you quite rightly pointed out, due to the inter-relationship between all the currencies, a change in value of one currency, is going to impact the cost of purchasing and selling all the others with that one currency, hence all the quotes are adjusted in quick succession (some more than others depending on the importance of it's relationship with the original currency). Although this is not the trade weighted index as described by the original reply to my OP, it is from what I can see a weighted value to some degree. There must be a measure of how each currency is valued and the weight of importance given to each currency compared to another, in order to assist each dealer in valuing the other currencies in response to a surplus or deficit in another currency.

Similarly, with each dealer constantly monitoring each other's quotes across the board, and with informed traders monitoring the true value of currencies, any discrepancy between quotes from different dealers is going to open up an arbitrage situation which other dealers or particularly fast traders will exploit. This will immediately have the effect of contributing to prices coming back in line across the board.

I think it is too simplistic to suggest that it is merely arbitrage which accounts for correlation (I know that is not what you claimed). If there is a large spike up in the EURJPY, and 2 seconds later there is a similar but less dramatic spike down in the USDCHF, this can't be entirely from arbitrage trades. For an arbitrage situation to arise, there has to be a discrepancy between quotes from different dealers, and for that to happen, there has to be a correct quote from some dealers and an incorrect quote from others. It is "how" dealers determine the correct bids and offers that I am most interested in.

I'm sure with more research I will eventually get to the correct definitive answer, but this is no doubt a very complex situation with many, many variables and contributing factors.

no problem. consider it my own personal vacation from my normal trollery. gotta change things up once in awhile to keep it all fresh.

honestly, i would encourage you to forget you ever heard the term 'trade weighted index'. i know next to nothing about it, but what i do know is that it has nothing to do with what you want to know.

the trade weighted index is merely a metric to represent where one currency is in relation to a bunch of others, as opposed to being compared to one specific currency. we are used to looking at things like EUR/USD.... well consider the trade weighted index to be something like (EUR,GBP,CHF,JPY,AUD,ABC,XYZ)/USD . it's purpose is to represent a currency in relation to whom it TRADES with, hence 'TRADE weighted index'. it's to gauge the overall import / export situation for the currency.

if i'm in the US and the US exports to australia, europe, and switzerland, then the US trade weighted index would be a metric representing the value of the US versus each of those countries. it would be (AUD,EUR,CHF)/USD. calculating this one value immediately gives one metric to show how good or bad the economy is in terms of being able to import/export.

so, again, forget ishii ever mentioned trade weighted index. you have wasted too much time on the completely wrong path. you can thank ishii for that.

you have it somewhat backwards. arbitrage is not what creates spikes or misquotes and whatever..... arbitrage is the entire incentive to NOT be out of line with what is deemed fair or accurate by the masses. it's not what causes price IMBALANCES, it is what keeps everything IN LINE. If you go into one store and buy a box of chocolates and then go next door and sell it to them at a higher price, wash, rinse, repeat, you will eventually put one or both businesses out of business (the one you buy from because you bought all their inventory and they can't buy it any cheaper anywhere else to recoup their losses, and the one you sell too because they can't sell it any more expensive and profit from this inventory they are overloaded with).

what you need to understand is this... when someone wants to convert a metric buttload of one currency for another and they call their direct line to Mr Joe Bank, Mr Joe Bank has to do a ring-around to other banks to see what they are all quoting and how much they are willing to take on-board. Mr Joe Bank gets a great overall view on how he can spread the risk amongst his fellow banks and at what rates. Mr Joe Bank then quotes his customer a worse price as a commission for doing business (pads the spread), takes the currency the customer is offering and gives the customer the currency s/he needs. now Mr Joe Bank can offload some or all of this currency he just received by giving portions of it to each of the willing other banks, and in return he can recoup some or all of the currency he just gave to the customer at a profit.

in this way the customer hasn't really exchanged with Mr Joe Bank, s/he has actually done the deal indirectly with a bunch of banks but just via his connection with Mr Joe Bank. the customer has actually taken the bought currency from the market at large, while distributing what s/he was offering to the market at large. the deal was done with Mr Joe Bank, but this transaction was then spread amongst the market at large by Mr Joe Bank, and Mr Joe Bank got to pocket some commission from you buy quoting you a worse price than the interbank rates were actually at.

edit : see link in next post

nubcake, we are on the same page. I am just obviously not very good at explaining myself. What you have said in the above post is pretty much exactly what I have also discovered and what I was trying to articulate. It's the relationship between dealers quoting each other which determines the price.

My reference to arbitrage was more a point of saying I didn't believe arbitrage was the reason for the correlation as many posters in this thread had been claiming. I completely understand that arbitrage will take advantage of mis-quotes and force prices back to an accurate value. Arbitrage traders punish dealers for getting their quotes wrong, but they do not influence the initial price quotes. It was what determined a "correct" price quote I was interested in.

I've been reading Larry Harris and he is going a long way to explaining this relationship between dealers which influences the prices and correlation. I am understanding it more clearly in my own head, but I am just not skilled enough to put it in to a concise explanation on paper.

cool cool.

edit : scrap all that... just read here : http://www.investopedia.com/articles...#axzz1ezhXypGU

the bottom-line to your question as to how does a pair get any number as it's quote comes back to any market where you have some people who are willing to buy, and some willing to sell. the point where the are at a stand-off facing each other is the bid/ask. market orders from there consume this and move the line forward and back which will then be filled by new limit orders and whatnot as price gyrates around. in this case the order book just happens to be split into separate books amongst the banks.

i know it's not actually that simple and there are different things happening each moment, but that's the simple way to look at it.

no more edits.

further to this... did some light reading to refresh the memory. it seems you are right about the traffic mostly being from inside the market itself as they risk their own capital to make further profits. market makers trying to reap the spread as well as prop strategies attempting to capture moves yadda yadda yadda mixed in with some actual outside customers wanting to get in on the action.

so in that case it becomes the case of who is quoting what and who is getting bumped into being long or short a currency taking on risk that they would otherwise prefer to be flat on just earning spread costs.

Why strong correlation? Carry trade and risk appetite

Basically currencies can be divided into two group, the beta aka 'risk-on' currencies and the 'safe haven' currencies. Risk currencies are countries where interest rates are set higher than the rates of their counterpart's country 'safe haven' currency'

Large percentage of FX flows are created by the investment side, eg hedge funds. Only a small percentage of FX transactions are made for commercial purposes.

Since all of us are living in a globalized economy right now, these fund managers will want to look out for yields and opportunities abroad.

To do so, they will borrow currency with lower rates and use the funds to invest in currencies with higher rates. In a prospering world economy, these funds will make a killing not just from the assets they invested in that country but also collecting higher interest rates and appreciating exchange rate (recall that currency of a country with higher interest rate is always stronger than the one lower than it) and from whatever gains from securities they bought in the country (equities etc)

In a uncertain world economy, carry trade movement will reverse, with fund managers liquidating their holdings in the country with higher rates and exchange back for the currencies they originally borrowed in lower rates.

So in our current situation, Eurozone's interest rate is now at 1.25% and in US rate is at 0.25%

In a world where economy is growing, stable and risk appetite is high, EUR/USD will go up. The opposite is true when there are uncertainties. This risk on/off movements moves across the currencies board, hence explaining the correlation. This correlation is not only just between currencies but also with equity indexes and bonds.

Hi all
There is a relation as you said but sometimes itbdoes take time to other currencies to move .this market is like a theromstaite you deal with reserves that are balanced by central banks you add to it at most rather than taking from it i think it solved a big problem in finicial system
As it keeps liquidty inreach ofbcentreal banks to some extent i think this market solved a lot of problems just trade what you offer to lose and would not change your life style or effect it
All have a nice day

Correlations come and go or persist over a long time if country relations persist. Certainly major pairs (USD, EUR, JPY, GBP) will continue to affect each other on a regular basis. Certain currency pairs are closely related, even correlated, at various times depending upon various economic factors such as country trading relations, central bank policies, economic news, etc. An example of closely related currencies would be the EUR and CHF. Geography and economic ties also tend to go together. For example, Australia and New Zealand will remain tied as currencies, just as the US and Canada.

But it's not just currencies that rapidly affect other currencies, it's basically all financial markets --currencies, commodities, stocks, bonds affecting each other in a vast web of financial interaction. A good sight for seeing a snapshot of various financial markets is Finviz.
http://finviz.com/futures_performance.ashx