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The US Dollar Index

The Dollar Index is a very useful yet simple to understand tool for currency, commodity and equity traders. The index measures the fluctuations of the US Dollar against a basket of different currencies: Euro, Japanese Yen, Canadian Dollar, British Pound, Swedish Krona and Swiss Franc (the Forecast Service provides market projections for currencies and many other asset classes. Send an email to info@hypervolatility.com and get a free 14 days trial). In practical terms, the Dollar Index tries to quantify how much the US dollar is appreciating or depreciating with respect to some of the most important and traded currencies in the world. The reason the Dollar Index is a valuable instrument for many traders is primarily due to its correlation to other asset classes and particularly risky assets.

As previously mentioned, the Index tracks the performance of the American dollar against a basket of other currencies, however, each exchange rate has a different weight. Specifically, the Index is a weighted geometric mean whose components and respective weights are the following: Euro (56.7%), Japanese Yen (13.6%), British Pound (11.9%), Canadian Dollar (9.1%), Swedish Krona (4.2%) and Swiss Franc (3.6%). The Index has 100 as a benchmark value therefore every reading below this threshold would imply a depreciation of the American currency against the basket, primarily the Euro, while any value above it is obviously indicating an appreciation. It goes without saying that the reason the Dollar Index has been trading below the 100 level for so long is the axiomatic consequence of the strength of the Single currency. It is clear that the Euro, whose weight in the Dollar Index calculation is 56.7%, is the most important currency since its impact is by far the heaviest. Obviously, every appreciation of the Single currency will impact negatively on the performance of the dollar and the next chart evidently displays such relationship:

Dollar Index

The above reported chart evidently displays the natural inverse relationship between the 2 markets and the obvious contrary fluctuations can be used to hedge potential currency based portfolios. In particular, the Euro, which is considered to be a risky asset, is positively correlated to equity indices therefore a drop in the Single currency would automatically correspond to a rise in the Dollar index. However, the positive correlation amongst Euro futures and other equity indices (such as E-Mini S&P500, DAX or Nasdaq futures) would suggest that a down trend in the Single currency is likely to be accompanied by a retracement in many risky assets. Therefore, the Dollar Index, being a “contrarian market by default”, could be very useful to detect market nervousness and cover unstable positions in equities. In order to better understand how much the American currency is linked to its components we will analyze the volatility fluctuations of the most important exchanges: Euro, British Pound and Japanese Yen futures. The reason we chose these 3 currencies is related to their weights, in fact, the combination of the aforementioned asset classes is responsible for 82.2% of the Dollar Index’s oscillation (Euro 56.7% + Japanese Yen 13.6% + British Pound 11.9%).

Dollar Index

The calculation tracks the volatility performance of the Dollar Index, Euro futures, Japanese Yen futures and British Pound futures. It is evident that the oscillations are more or less correlated, in fact, the volatility decreased for all asset classes in January, April – May, August – September and November – December but drastically augmented in February, June – July and October. Undoubtedly, every market behaved differently in the short term but the macro movements are very correlated each other. This information is very important to forex traders because it proves that the Dollar Index, in terms of magnitude, moves as much as the other currencies implying that it could be used as a hedging tool when the Euro or the British Pound are in downtrend (the behaviour of the Japanese Yen is different and it will be treated separately later on). Let’s have a look at the relationships amongst the aforementioned exchanges from a quantitative point of view:

Dollar Index

The table presents the correlation and covariance of each asset class against the Dollar Index and the results stress what have been previously stated: the Index obviously has an extremely strong negative correlation to the price of the Euro (-0.93) and a strong negative correlation to the price of the British Pound (-0.66). However, Euro and British Pound volatilities display a strong positive connection to the Dollar Index, in fact, the correlation coefficients are +0.79 and +0.69 respectively. The positive connection in volatility is an obvious consequence of the fact that the rise in the Dollar Index will always be proportioned to the depreciation of the remaining currencies, hence, the movement will be fairly similar in terms of magnitude. The covariance of Euro and British Pound prices with respect to the value of the dollar (the covariance measures the mutual variability of 2 random variables) is negative, -0.16 and -5.04 respectively, which is another natural consequence of the appreciation of the American currency against European exchanges. On the other hand, the volatility covariance is positive, 1.95 and 1.73 respectively, implying that Euro and British Pound volatilities rise when the volatility of the Dollar Index rises and vice versa. The reason volatilities move in the same direction is because both markets observe a leverage effect process: the volatility tends to rise when the price action is in downtrend. Specifically, a drop in Euro and British Pound futures would probably cause an increase in market volatility but a rise in the Dollar Index would increase its volatility too. In other words, risky assets such as Euro or British Pound futures follow a leverage effect process while the Dollar Index is governed by an inverted leverage effect: the volatility increases with a larger buying pressure and decreases in case of a sell–off. Consequently, If Euro and British Pound futures are plunging they are effectively depreciating against the Dollar. Therefore, the volatilities of the 2 European asset classes, following a leverage effect process, will increase while the appreciation of the Dollar will push the Dollar Index up and the buying pressure would increase its variance too.

The Japanese Yen, instead, needs a different approach. First of all, it is necessary to remind that the Asian currency is often used as a hedging tool in portfolio management because many market participants rush to buy Yen when equities drop. Secondly, it is important to point out that the “safe haven role” played by the Japanese Yen has a clear implication: the volatility rises when the market heads north (if you are interested in hedging portfolio risk you may want to read the HyperVolatility research entitled “Portfolio Hedging: Risky Assets vs Safe Havens”). As we can see, Japanese Yen futures, as well as the Dollar Index, are popular assets when equity indices and single stocks are plummeting and their volatilities are both driven by an inverted leverage effect process. The positive price correlation between Dollar Index and Japanese Yen futures (+0.10) and the weak covariance (-0.26) evidently proves the point just made. The price correlation is clearly very low and the negative, although feeble, covariance indicates that the buying pressure was sometimes stronger for the Asian currency. The numbers suggest that in 2012 the Dollar Index and Japanese Yen futures have been both used as a hedging tool but in a diverse fashion because the buying pressure was evidently different.

Conclusions

The Dollar Index is a very simple to understand tool for traders and it is worth monitoring when investing. Here are some important points to bear in mind:

1) The benchmark value for the Dollar Index is 100. If the Index is below this level the dollar is depreciating against other currencies while a reading above this threshold implies an appreciation of the American currency

2) The Dollar Index is a weighted geometric mean whose components and respective weights are the following: Euro (56.7%), Japanese Yen (13.6%), British Pound (11.9%), Canadian Dollar (9.1%), Swedish Krona (4.2%) and Swiss Franc (3.6%)

3) The Euro is the currency that influences Dollar Index’s fluctuations the most

4) The volatility of the Dollar Index rises with an increasing buying pressure and decreases when the market goes down

5) Euro, Japanese Yen and British Pound are responsible for the 82.2% oscillations in the Dollar Index

6) The Dollar Index can be effectively used to hedge positions in Euro and British Pound futures

7) Japanese Yen futures do not show much correlation to the Dollar Index because of their “safe haven” characteristics

8) The Dollar Index, given its “contrarian nature” is a rather good asset to hold when risky assets (equities, stocks, etc) plunge

The HyperVolatility Forecast Service enables you to receive the statistical analysis and projections for 3 asset classes of your choice on a weekly basis. Every member can select up to 3 markets from the following list: E-Mini S&P500 futures, WTI Crude Oil futures, Euro futures, VIX Index, Gold futures, DAX futures, Treasury Bond futures, German Bund futures, Japanese Yen futures and FTSE/MIB futures.

Send us an email at info@hypervolatility.com with the list of the 3 asset classes you would like to receive the projections for and we will guarantee you a 14 day trial.

British Pound Futures Volatility Forecast (05/10/2011)

British Pound futures opened at 155.4 on Monday, jumped to 156.3 on Tuesday, retraced to 155.8 on Wednesday, settled at 156 on Thursday and closed at 155.7 on Friday.

The actual volatility is 0.53% (8.4% annualised) and the TGARCH plot is showing an upward sloping curve which is trying to complete its mean reverting process towards the long term equilibrium point which is stable around the 0.55% level (8.7% in annual terms).

However, the spread between the current level and the balance threshold is not that striking and consequently there should not be violent moves to be expected over the next trading hours.

The HyperVolatility is slightly bearish British Pound futures because the increase in the conditional variance should push the price action toward the 152.8 – 153 level before Friday.

Nevertheless, further bad macroeconomics news could easily drag futures prices even more down because investors would rush to buy US dollars whose value would irremediably appreciate against all other European countries. Should the last scenario occurs we would see British Pound futures retest the 150 support.

British Pound Futures Volatility Forecast (27/09/2011)

British Pound Futures opened at 156.6 on Monday and settled at the same price on Tuesday, dropped to 154.9 on Wednesday, touched 153.4 on Thursday and settled at 154.7 on Friday.

The current volatility is 0.57% (9% in annual terms) and the volatility curve is evidently displaying an upward sloping trend which is a natural consequence of the large plunge the price action experienced over the last week. On the other hand, the conditional variance has now touched its 5 months high and an ulterior explosion of the fluctuations rate should be considered very carefully.

The large retracement in the market was caused by a sharp appreciation of the dollar which has been, in turn, provoked by the sell-off that hit financials the last week.

The HyperVolatility team is moderately bullish British Pound futures because the conditional variance will probably tend to soften over the next trading days supporting the price action which is likely to retest the 156 – 157 area by Friday.

Needless to say that the US dollar remains one of the few safe havens left and therefore a worsening of the European sovereign debt crises would push more and more traders to long the greenbacks and short Her Majesty’s currency: another delicate week ahead!!

British Pound Futures Volatility Forecast (19/09/2011)

British Pound futures opened at 158.4 on Monday, dropped to 157.77 on Tuesday, closed at 157.71 on Wednesday, jumped to 158 on Thursday and settled at 157.9 on Friday.

The current volatility is 0.54% (8.5% in annual terms) but the volatility curve seems to have reached a mean reverting point and it looks like that the upcoming trading days will probably see a softening of market fluctuations. However, British Pound futures went through a bearish week, that caused the conditional variance to increase, and the fact that the volatility is now ready to decrease is signalling that the down move is likely to be over.

The fact that the conditional variance is still high means that some short term bursts are still possible, however, the overall week should see British Pound futures in a shy uptrend. Consequently, the 1.60 area could be eventually retested by the end of the week.

Finally, the FOMC statement on Wednesday remains the key event of the week and should be carefully monitored.

British Pound Futures Volatility Forecast (06/09/2011)

British Pound futures opened at 164 on Monday, plummeted to 162.8 on Tuesday, plunged to 162.4 on Wednesday, settled at 161.8 on Thursday and closed at 162.1 on Friday.

The current volatility is 0.51% (8% in annual terms) and the TGARCH plot is displaying a steady volatility curve whose inclination is neither upward nor downward sloping. However, the absence of short term explosion of the conditional variance looks a bit suspicious if compared to the price action that has been plummeting all week long.

There is clearly a violation of the leverage effect process going on because the volatility is not reflecting the actual market conditions. Usually, such a mismatch is a warning signal and it tends to precede drops in the price action.

The HyperVolatility team is bearish British Pound futures because an increase in the conditional variance should now accompany a plunge in futures prices which are likely to retest the 158 – 159 area by Friday.

British Pound Futures Volatility Forecast (30/08/2011)

British Pound futures opened at 164.6 on Monday, rose to 164.9 on Tuesday, dropped to 163.6 on Wednesday, plummeted to 162.8 on Thursday and closed at 163.6 on Friday.

The actual volatility is 0.51% (8% in annual terms) and the TGARCH chart is showing again a fairly stable volatility curve which is obviously trading within its long term equilibrium point. Also, the mean reverting speed is fairly high because every spike far from the mean gets quickly annulled by an offsetting movement of the conditional variance. The steadiness rate of the curve should probably remain unchanged even in the upcoming days and there should not be big jumps or unexpected large volatility bursts; although some very short term retracements are inevitable.

Consequently, the dollar should keep depreciating against British Pound even in the next hours, macroeconomics news permitting.

The HyperVolatility team remain bullish British Pound futures because the conditional variance should not change dramatically and such a phenomenon should back the price action which should eventually retest the 165.5 – 166 area by Friday.

However, some sideways movements around the resistance point placed at 165 are quite likely to happen but the accumulation period, ceteris paribus, should be followed by a break out of the aforementioned level.

British Pound Futures Volatility Forecast (22/08/2011)

The last week’s worst scenario analysis suggested a jump of British Pound futures in the 163 – 164 zone and effectively so it was. In fact, the bad macroeconomics data added to the delirium of Germany and France prime ministers contributed to destroy the last hope of recovery.

British Pound futures opened at 163.7 on Monday, touched 164.5 on Tuesday, jumped to 165.3 on Wednesday, dropped to 165.1 on Thursday and closed at 164.7 on Friday.

The actual volatility is 0.53% (8.4% in annual terms) and the TGARCH plot is visibly displaying a fairly stable curve, although slightly upward sloping, which has now touched its long term equilibrium point implying that the next days could see a similar amount of fluctuations in futures prices.

The great uncertainty and fear surrounding most of the equity markets is pushing many investors and traders to buy more and more dollars. At the same time the European debt crises is keeping money away from the Pound Sterling and the Euro whilst big flows are observed towards Swiss Franc and Japanese Yen.

The HyperVolatility team is moderately bearish British Pound futures because the volatility should keep increasing, although sensibly, in the upcoming trading sessions implying a further drop of the price action which could retest the 162 area by the next Friday.

Additionally, an ulterior violent plunge of equity markets would make the US dollar appreciate even more against European currencies and futures prices could even hit the 160 support level should the sell-off be as aggressive as the one we saw in the previous 10 trading days.

British Pound Futures Volatility Forecast (14/08/2011)

The HyperVolatility team was bearish British Pound futures and we were expecting the market to retrace sharply and retest the 161.5 area and on Wednesday our profit target was successfully achieved. Specifically, British Pound futures opened at 163.3 on Monday, touched 163.12 on Tuesday, dropped to 161.32 on Wednesday, achieved 162.22 on Thursday and closed at 162.75 on Friday.

The actual volatility is 0.43% (6.8% annualised) whilst the chart is showing an upward sloping curve which seems suggesting that, over the next trading days, an increase in the fluctuation rate should be expected. Furthermore, it is interesting to notice that the conditional variance plummeted quite sharply, although the market retraced rather violently in the first 2-3 days of the last week, implying a positive correlation between British Pound futures and their volatility.

The US dollar should probably keep appreciating against Her Majesty’s currency because investors will try to “secure” their capitals for one more week before getting back to riskier markets.

The HyperVolatility team is bearish British Pound futures because the augment in the oscillation rate should hit prices in the upcoming week. It would not be surprising to see the market to retrace and test the 160 support by Friday.

On the other hand, should equity markets move sharply up, over the next days, British Pound could eventually head north and touch the 163.5 – 164 level.

British Pound Futures Volatility Forecast (08/08/2011)

The uncertain fluctuations that Her Majesty’s currency experienced are clearly due to the enormous indecision and fear about US economy. Last week the British Pound futures opened at 162.9 on Monday and stayed at that level on Tuesday but increased to 164.1 on Wednesday, dropped to 162.3 on Thursday and closed at 163.8 on Friday.

The actual volatility is 0.42% (6.6% annualised) and the TGARCH plot is now showing a downward sloping curve which is far from its medium term equilibrium point which is set around the 0.5% threshold (7.9% annualised).

The low volatility of British Pound futures, despite the wild oscillation observed in other markets, it is a warning signal and the fluctuations rate is very likely to augment over the next trading hours causing the US dollar to appreciate against the Sterling.

Furthermore, it is important to point out that, although the US debt has been downgraded, the US dollar remains the main reserve currency for many countries and many investors still consider it as a counterbalancing asset against equity indices drops.

The HyperVolatility team is bearish British Pound futures because the volatility should increase, at least in the short term, dragging prices back down in the 161.5 area by Friday.

Should things get worst for equity indices the US dollar could appreciate even more and British Pound futures would plunge to 159 – 160 in the worst scenario.

British Pound Futures Volatility Forecast (08/02/2011)

British Pound futures opened at 162.6 on Monday, rose to 164 on Tuesday, dropped to 163.1 on Wednesday, settled at 163.4 on Thursday and closed at 164 .08 on Friday.

The current volatility is 0.31% (4.9% annualised) and the TGARCH is showing an upward sloping curve whose analysis seems suggesting that the upcoming days will see an increase in price fluctuations.

Furthermore, British Pound futures are very close to the historically robust resistance point placed at 1.65 and only an ulterior strong depreciation of the US dollar caused by severe macroeconomics news could push investors above this level.

The HyperVolatility team is bearish British Pound futures because the volatility curve should augment in the upcoming days causing an ulterior weakening of the price action whilst the strong psychological threshold, that is1.65, should not be violated.

Consequently, a short term augment of the conditional variance is likely to drag futures prices back down in the 161 zone by Friday.

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