The interrelated behavior of exchange rates

Diversification is a possible means of reducing the risk of holding foreign currencies. However, a key consideration is the basic assumption of how well-correlated the exchange rates are for the specific currencies. An empirical analysis was done to examine the correlation between currency movements. The analysis involved the computation of a set of Pearson correlation matrices for the period 1974-1980, with the US dollar being the base currency. Other currencies considered included the English pound, German mark, French franc, Yen, Italian lira, Swedish krone, Canadian dollar, and Dutch florin. The results of the analysis showed stable correlation coefficients of currency fluctuations on a proportional basis, with most correlation relationships being positive. A second analysis was done using the Dutch guilder as a base currency, which resulted in a significant decrease in most correlation coefficients. Also, the factors of time horizon and frequency of data observations had a minor impact, while the deletion of subperiods, such as a year, had a significant impact.