21.6.11

How to build a currency basket? II

In the first article, we predefined a fix number of currencies (AUD, CAD, CHF, USD, and GBP), and we calculated a reasonable portfolio to hedge against EUR. In this second article we want to determine why these currencies and why we started using 20% of each one when some of them behave approximately the same. For instance, AUD and CAD have a high correlation and if we use them separately we are overweighting their importance in our basket.

Sometimes it´s better to show not-so-easy concepts through simple examples. Let´s imagine that we live in UK. Our main currency is GBP, then. However we travel a lot and are quite flexible to live in other countries. Besides we don´t trust GBP that much, so as to have all our wealth in this currency. We keep on imaging that we have a salary of 2000 GBP a month, but have 500.000 GBP equivalent to invest. Again, as in the first article, we are not talking about the instruments we are going to use to invest, but only about our currency exposure.

First thing we need to know is if certain currencies are highly correlated. If this is the case, they behave as one. To check out correlation patterns there are many calculators like this one from Mataf Forex. As we are long term investors, we select the currencies we want to display in the table, 200 in "Number of periods" and we just look at the weekly table, the last one. In general, on one side we have USD and the rest on the other side. So, if we choose EURUSD, AUDUSD, USDCAD, USDCHF, and GBPUSD, we will see that AUDUSD and USDCAD are highly correlated (-91.8, negative because in the first one USD is in the denominator and in the second one in the numerator), so it makes sense to consider AUD and CAD as one currency. Amazingly, AUD and CAD are also highly correlated with CHF.

Second, we check if these correlations are stable. If we pivot our currencies around GBP, AUD-CAD-CHF have a correlation greater than 80%. We check this correlation out with different periods and somehow it´s valid. So let us consider these 3 currencies, AUD, CAD, and CHF as one (1/3), EUR (1/3), and USD (1/3).In the point 8 of the first article, instead of 20% of the formula, we use 11% for AUD, CAD, and CHF, 33% for USD, and 34% for EUR.

As a result, with the data from the article I, our portfolio would be: CHF>7%, AUD>13%, CAD>11%, EUR>33%, and USD>36% taking into account that we have supposed that our home currency is GBP.

22/6/2011