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Decimal Digest
30 Apr 2012

Curious Case of Correlation between Indian Rupee and European Bank Index

This week, we look at the correlation between two diverse asset classes, namely, European Banks and INRUSD pair. Normally, one should not find any correlation, either positive or negative between these two assets, since they do not seem to have anything particular in common. However, the current crisis has created strange bedfellows. From the onset of the crisis, a majority of assets globally have only two states – risk-on state and risk-off state. As a result, we find significant negative correlation between INRUSD and European Bank Index. Indian Rupee depreciates when European bank stocks seem to be faltering, and it appreciates when European banks gain strength.

The following chart and table visually depicts the negative correlation:

Chart 1: Price movement of European bank index and INRUSD

Source: RBI, Decimal Point Analytics

Table 1: Correlation of returns of various holding periods since Jan 2008 between European Bank Index and INRUSD

Source: Decimal Point Analytics

Smart asset managers who believe that the economic conditions seen in recent past are likely to prevail for some more time in future, can use this relationship between two diverse assets to create a portfolio beating efficient frontier.


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