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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.

Euro Futures Volatility Forecast (05/10/2011)

Euro futures opened at 1.3509 on Monday, achieved 1.358 on Tuesday, dropped to 1.3552 on Wednesday, retested the 1.3576 area on Thursday and plunged to 1.3388 on Friday.

The current volatility is 0.76% (12% annualised) and the TGARCH plot is evidently displaying a fairly stable curve which should probably remain around this level in the upcoming hours.

The great uncertainty surrounding the Euro zone could keep the selling pressure pretty high but the fact that the fluctuations rate is still trading in a fairly “normal” range seems suggesting that the short term trend could change.

Clearly, most of the movements will be influenced by what politicians are going to say/do in order to ring fence a potential Greek sovereign debt default  implying that a great deal of attention to public speeches will be needed.

The HyperVolatility team is moderately bullish Euro futures because the stable outlook of the volatility curve should support the price action which could eventually retest the 1. 3500 area by Friday.

Euro Futures Volatility Forecast (27/09/2011)

Euro Futures opened at 1.36 on Monday, remained unchanged on Tuesday, plummeted to 1.35 on Wednesday, plunged to 1.346 on Thursday and closed at 1.35 on Friday.

The volatility is now 0.8% (12.6% annualised) and the TGARCH curve is neither upward nor downward sloping even if the very last part of the plot seems suggesting a shy increase in the conditional variance. However, the fluctuations rate is now very far from its medium term equilibrium point which ranges between the 0.73% – 0.77% area (11.5% – 12.2% in annual terms).

The first half of the week could see the Single currency to depreciate against the US dollar because the oscillation rate is still looking at the northern part of the chart but it is likely that the rumours about the 2 -3 trillion euro package to save Europe from financial catastrophe will provoke some speculative buying.

European leaders are now calling for a more concrete action to bail out Greece (later is better than never) and to prevent the crises from spreading to too-large-to-be-saved countries (read Italy and Spain): we will see if facts will follow words because the latter are cheap but the former are not!!!

The HyperVolatility team is moderately bullish Euro futures, even if the first half of the week could see another downside move, and the conditional variance should soft over the next trading hours whilst the price action should eventually retest the 1.3600 – 1.3700 area by Friday.

Needless to say that an ulterior macroeconomics shocks would irremediably drag futures prices down as more and more investors will rush to buy US dollars.

 

Euro Futures Volatility Forecast (19/09/2011)

Euro futures opened at 1.3653 on Monday, touched 1.368 on Tuesday, rose to 1.375 on Wednesday, jumped to 1.3881 on Thursday and settled at 1.3788 on Friday.

The actual volatility is 0.7% (11.1% in annual terms) and the TGARCH plot is evidently displaying a sharply downward sloping curve which is now trying to get back to the 0.6% level (9.5% annualised). However, it is worth noting that the volatility, at least over the last week, has been closely following the price action giving birth to a symmetric leverage effect although the big spike has been primarily caused by the big drop which dragged futures prices from 1.41 to the 1.37 area.

The great uncertainty which is surrounding financial markets is mainly due to Europe and its future therefore many traders will probably keep the exchange rate at historically low level unless concrete measures to avoid Greece’s default and prevent sovereign debt contagion will be taken.

The HyperVolatility team is moderately bearish Euro futures because the drop in volatility, in this case, will accompany a further depreciation of the Single currency against the Dollar. Therefore, the 1.3400 – 1.3450 threshold could be retested before the end of the week but the FOMC announcement on Wednesday could twist the scenario.

Euro Futures Volatility Forecast (06/09/2011)

Euro futures opened at 1.4504 on Monday, plunged to 1.4439 on Tuesday, settled at 1.437 on Wednesday, plummeted to 1.4267 on Thursday and closed at 1.4193 on Friday.

The actual volatility is 0.73% (11.5% in annual terms) and chart is evidently showing an aggressively upward sloping volatility curve which seems to suggest that a higher degree of market fluctuations should be expected in the upcoming hours. Unlike British Pound futures the plunge in Euro futures prices has been accompanied by a large selling pressure which inevitably lifted the conditional variance.

The concerns about the diminished growth in Europe in addition to the problems connected to the sovereign debt crises are going to augment the selling pressure in the short term.

The HyperVolatility team is bearish Euro futures because the conditional variance should rise in the short term whilst the price action is likely to retest the 1.3900 – 1.4000 area by Friday.

Euro Futures Volatility Forecast (30/08/2011)

Euro futures opened at 1.4358 on Monday, rose to 1.4441 on Tuesday, retraced to 1.4410 on Wednesday, jumped to 1.4376 on Thursday and closed at 1.4491 on Friday.

The actual volatility is 0.71% (11.2% in annual terms) and the TGARCH plot is displaying a stable volatility curve, although sensibly upward sloping, which seems suggesting that in the upcoming hours the market should not experience big jumps or sudden volatility bursts. Clearly, there could be some short term retracements but, even in this market, the mean reverting process tends to be very quick and powerful implying that all “odd moves” are likely to get averaged out.

The HyperVolatility is bullish Euro futures because the conditional variance should not augment in the short term and the price action should move upward over the next trading days. Consequently, futures prices should retest the 1.50 threshold by the end of the week although some short term drops are quite likely to occur but their impact should not be significant in the medium term.

 

Euro Futures Volatility Forecast (22/08/2011)

The forecast we gave you the last week proved very useful and profitable because the 1.4400 target has been successfully achieved by the price action over the last trading days. In fact, Euro futures opened at 1.4434 on Monday, dropped to 1.4401 on Tuesday, jumped to 1.443 on Wednesday, plummeted to 1.4332 on Thursday and closed at 1.4383 on Friday.

The actual volatility is 0.72% (11.4% annualised) and even this week the TGARCH chart is showing a fairly stable curve which seems not to mirror the great instability and uncertainty that is hitting all financial markets worldwide. Moreover, Euro futures volatility is trading within its long term equilibrium point and, even though the curve is upward sloping, there are no signals of any imminent explosion of the conditional variance although some short term increase is not to exclude.

The situation in US is not really comforting whilst the European debt crises is making everybody more and more concerned about the future of the global economy. Consequently, many traders and investors are purposely avoiding this market, which was one of the few not to experience wild fluctuations, because they switched their attention towards more “popular” asset classes.

The HyperVolatility team is moderately bullish this market because there should not be short term explosion of the volatility and the upcoming trading hours should see a sideways movement of the price action followed by a recovery of futures prices which could retest the 1.4500 threshold by Friday.

It is worth noting that ulterior bad news coming from European peripheral countries could trigger a massive sell-off which would irremediably see the US dollar to appreciate against the Single currency whose closing value could touch the 1.4000 zone.

Euro Futures Volatility Forecast (14/08/2011)

The futures on the Euro-Dollar have been trading in a very narrow range despite the high volatility and wild swings that other markets experienced over the last 5 trading days. In fact, Euro futures opened at 1.4177 on Monday, rose to 1.4365 on Tuesday, dropped to 1.4185, achieved 1.4217 on Thursday and closed at 1.4247 on Friday.

Euro futures, unlike other markets, did not experience aggressive movements , and therefore violent price swings, which would have otherwise sent the volatility through the roof.

The current volatility is 0.72% (11.4% in annual terms) and the TGARCH plot is clearly showing a curve which is neither upward nor downward sloping. The conditional variance is now trading close to its long term average, that is between 0.68% – 0.7% (10.7% – 11.1% annualised), and apparently there are no signs of any imminent explosion of futures prices in the near term.

The US dollar should depreciate, at least in the short term, against the Single currency and the really low fluctuations rate, if compared to other markets, is a warning signal that should not be ignored.

The HyperVolatility team is bullish Euro futures because the volatility should increase along with the price, in an inverted leverage effect process, which should push futures back in the 1.4400 – 1.4500 by Friday.

However, a great deal of attention is needed for this market since investors do not trust neither the US dollar nor the Euro because, given the situation of the economy in both the States and Europe, it would be like choosing to get hit with a big stone or a hammer.

Euro Futures Volatility Forecast (08/08/2011)

The Single currency moved almost like the Pound and, even in this case, it is worth mentioning that such random oscillations of the price are just a consequence of the huge concerns about the US economy. In fact, Euro futures opened at 1.4231 on Monday, dropped to 1.4186 on Tuesday, jumped to 1.4301 on Wednesday, dropped to 1.4082 on Thursday and closed at 1.4277 on Friday.

The current volatility is 0.71% (11.1% in annual terms) and the TGARCH plot is clearly showing a volatility curve which is slightly upward sloping although it seems it has reached its medium term equilibrium point which is set to be around the 0.7% level (11.1% annualised).

The big drop of the S&P500 and the US debt downgrading will probably add pressure to the price action and increase the volatility in the short term. As mentioned for other analysis many investors will try to protect their portfolios and therefore large amount of capitals could flow from the equity indices towards the US dollar causing an appreciation of the greenback.

The problem is that many investors are now deciding between the least painful choices: US debt downgrading or Europe instability crises?

The HyperVolatility team is bearish Euro futures because the conditional variance should now head north provoking an appreciation of the greenback against the Single currency. Hence, Euro futures are likely to retest the 1.395 – 1.4000 area by Friday.

The situation in Europe is pretty bad with Spanish and Italian yields very close to the 7% warning zone. The ECB announced it would buy Spanish and Italian sovereign debt securities directly from the secondary markets but we do not think that such an intervention will be enough to cool down this hot summer.

Euro Futures Volatility Forecast (02/08/2011)

Euro futures opened at 1.4356 on Monday, moved to 1.4486 on Tuesday, plummeted to 1.4346 on Wednesday, settled at 1.4297 on Thursday and closed at 1.4368 on Friday.

The actual volatility is 0.68% (10.7% in annual terms) and the TGARCH chart is clearly showing a curve which has now completed its mean reverting process and it is not trading within its long term equilibrium point although still upward sloping.

Euro futures are trading just below the resistance placed at 1.4500 – 1.4550 and a breakthrough of this important psychological point could be possible in the near future but in order to remain above the aforementioned threshold the next news regarding the US economy such as NFP and unemployment should be very bearish causing the US dollar to depreciate even more against the Single currency.

The HyperVolatility team is bullish the Euro futures market because the steadiness of the volatility plot should be a good indicator for the robustness of the uptrend we all saw since the beginning of July. Consequently, the price action should keep rising and eventually touch 1.4580 by Friday.

Nevertheless, some short term explosions of the conditional variance could alter the picture but the overall trend should remain unchanged and therefore bullish.

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