FX Correlation

How currencies move with assets or other currencies — key for diversification.

FX correlation determines whether currency exposure adds or reduces portfolio risk. Risk-on currencies (AUD, NZD, EM currencies) strengthen when equities rise (+0.3 to +0.6 correlation with stocks)—they amplify equity risk. Safe-haven currencies (JPY, CHF) strengthen when equities fall (−0.3 to −0.5 correlation)—they provide natural hedging. Example: Holding Japanese equities with JPY exposure creates a hedge — when Japanese stocks fall, JPY often appreciates, cushioning losses. Currency pairs: EUR/USD and GBP/USD are highly correlated (+0.7 to +0.9), while USD/JPY and AUD/USD are weakly correlated. Understanding FX correlations is critical for global portfolio construction — unhedged FX can either enhance or destroy diversification depending on correlation regime.

Formula

\rho_{\text{FX,asset}} = \frac{\text{Cov}(R_{\text{FX}}, R_{\text{asset}})}{\sigma_{\text{FX}} \sigma_{\text{asset}}}

Related Terms

FX Risk

Risk from exchange rate fluctuations affecting foreign-denominated assets.

Covariance Matrix

Captures how asset returns move together — the foundation of diversification.

Portfolio Volatility

Standard deviation of portfolio returns — total risk including diversification effects.