A:

The correlation between any two variables (or sets of variables) summarizes a relationship, whether or not there is any real-world connection between the two variables. The correlation coefficient will always be between -1 and +1. These two extremes are considered perfect correlations. A negative coefficient means that the two variables, or sets of variables, will move in opposite directions (if one variable increases, the other will decrease); a positive coefficient will mean that the two will move in the same direction (as one increases, the other will increase).

If we compare the US Dollar Index (USDX), an index that tracks the value of the U.S. dollar against six other major currencies, and the value of the Dow Jones Industrial Average (DJIA), Nasdaq and S&P 500 over a 20-year period, the correlation coefficient calculated for the USDX versus the DJIA, Nasdaq and S&P 500, is 0.35, 0.39 and 0.38, respectively. Note that all of the coefficients are positive, which means that as the value of the U.S. dollar increases, so do the stock indexes, but only by a certain amount. Notice also that each coefficient is below 0.4, which means that only about 35% to 40% of the stock indexes' movements are associated with the movement of the U.S. dollar.

A country's currency can become more valuable in relation to the rest of the world in two main ways: when the amount of currency units available in the world market place is reduced (for example, when the Fed increases interest rates and causes a reduction in spending), or by an increase in the demand for that particular currency. The fact that an increase in the U.S. dollar affects the value of American stocks seems natural, as U.S. dollars are needed to purchase stocks.

The value of American stocks, especially those that are included in market indexes, tend to increase along with the demand for U.S. dollars - in other words, they are positively correlated. One possible explanation for this relationship is foreign investment. As more and more investors put their money in U.S. equities, they are required to first buy U.S. dollars, which can be used to purchase American stocks, causing the indexes to increase in value.

For more insight, see Commodity Prices And Currency Movements and Using Currency Correlations To Your Advantage.

RELATED FAQS
  1. What is the difference between a copay and a deductible?

    Learn how the correlation coefficient may be used to predict the relationship between the returns of two stocks, but also ... Read Answer >>
  2. What does a negative correlation coefficient mean?

    Discover the meaning of a negative correlation coefficient, how this compares to other correlation coefficients and examples ... Read Answer >>
  3. Can the correlation coefficient be used to measure dependence?

    Understand the coefficient of correlation and its use in determining the relationship between two variables through the concepts ... Read Answer >>
  4. How does correlation affect the stock market?

    Learn about the role correlation plays in prudent stock market investing, and how the correlation coefficient is used to ... Read Answer >>
  5. What Does it Mean if the Correlation coefficient is Positive, Negative, or Zero?

    When a coefficient is greater than zero, it is a positive relationship; when the value is less than zero, it is a negative ... Read Answer >>
  6. How can you calculate correlation using Excel?

    Find out how to calculate the Pearson correlation coefficient between two data arrays in Microsoft Excel through the CORREL ... Read Answer >>
Related Articles
  1. Investing

    What's the Correlation Coefficient?

    The correlation coefficient is a measure of how closely two variables move in relation to one another. If one variable goes up by a certain amount, the correlation coefficient indicates which ...
  2. Investing

    Is the Stock Correlation Strategy Effective?

    The synchronized movement among stocks and markets in recent years is challenging diversification.
  3. Investing

    Understanding the Oil & Gas Price Correlation

    Learn how the correlation between the commodity prices for natural gas and oil changed from 2004 to 2015 due to increased natural gas production.
  4. Financial Advisor

    4 Reasons Why Market Correlation Matters

    Learn about how correlation can be used to measure how broader markets move in relation to each other. See how correlation is used to manage risk.
  5. Trading

    Using Currency Correlations To Your Advantage

    Knowing the relationships between pairs can help control risk exposure and maximize profits.
  6. Insights

    Prices of Stocks and Bonds Move More in Tandem

    Correlation between stock and bond prices in the U.S. have reached a 10-year high, reversing a broader trend of negative correlation.
  7. Investing

    Commodities: The Portfolio Hedge

    These diverse asset classes can provide downside protection and upside potential. Find out how to use them.
  8. Investing

    Regression Basics For Business Analysis

    This tool is easy to use and can provide valuable information on financial analysis and forecasting. Find out how.
  9. Trading

    Managing Currency Exposure In Your Portfolio

    The value of your investments is impacted by changes in global currency exchange rates. Find out how.
RELATED TERMS
  1. Positive Correlation

    A relationship between two variables in which both variables ...
  2. Negative Correlation

    In statistics, a perfect negative correlation is a relationship ...
  3. Coefficient of Determination

    A measure used in statistical model analysis to assess how well ...
  4. Inverse Correlation

    A contrary relationship between two variables such that they ...
  5. Serial Correlation

    The relationship between a given variable and itself over various ...
  6. Variable Cost Ratio

    Variable costs expressed as a percentage of sales. The variable ...
Hot Definitions
  1. Marginal Utility

    The additional satisfaction a consumer gains from consuming one more unit of a good or service. Marginal utility is an important ...
  2. Contango

    A situation where the futures price of a commodity is above the expected future spot price. Contango refers to a situation ...
  3. Stop-Loss Order

    An order placed with a broker to sell a security when it reaches a certain price. A stop-loss order is designed to limit ...
  4. Acid-Test Ratio

    A stringent indicator that indicates whether a firm has sufficient short-term assets to cover its immediate liabilities. ...
  5. Floating Exchange Rate

    A country's exchange rate regime where its currency is set by the foreign-exchange market through supply and demand for that ...
  6. Taxes

    An involuntary fee levied on corporations or individuals that is enforced by a level of government in order to finance government ...
Trading Center