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Thanks for sharing this.

I wonder how successful someone could be if they used your "toy" to make money by taking advantage of changes in the CAD/USD exchange rate? It appears it could be used as a Fx valuation tool much like "Graham Price" (amongst others) for individual stocks.

Hi Adam,

In theory you could look at the residuals (that is the gap between the actual vs. forecasted) and see if that was correlated with future rises/falls in the CAD/USD (or future rises/falls in the price of oil). There's probably something there, but I wouldn't be confident enough in it to start making large bets on forex/commodity markets - if I was, I would have kept MERT to myself and would be doing so now.

But maybe I should examine the issues of residuals. I'll try that in a future post.

One thing I have noticed is that the relationship starts to break down once oil goes over $82 or so a barrel and MERT starts predicting a dollar above parity. It could be that parity is acting as a psychological barrier that keeps the dollar down at this price point and once the dollar passed the barrier, the relationship would go back to normal. Unfortunately (or fortunately) there's not enough periods with a $90+ oil to test this.

I don't know if it's a psychological barrier, but *something* happens when the dollar hits parity. Whenever I do a scatter plot of oil and commodity prices against the exchange rate, the relationship looks stable up to parity, and then there's a sort of a kink in what had been stable linear relationship.

Yeah, the same thing happens in MERT. The only thing that makes me thing it's a psychological barrier is that it happens right at parity and not at a non-focal point such as 87 or 112 cents.

So, introduce the glass ceiling correction factor when it approaches parity.

"So, introduce the glass ceiling correction factor when it approaches parity."

That's the basic idea, yeah. Problem is, there's not enough data points to really determine what that factor looks like. In particular, do things go back to 'normal' once the psychological barrier is crossed, or does the Canadian dollar rise at a significantly slower rate than 0.62 per $1 increase in oil? I suspect it's the latter, but I'm not sure what the rate should be.

Any merit in trying to correlate to the TSX index for energy? The psychology might be factored in there.

I've noticed, observationally only, a recent (last few quarters?) strong correlation to risk assets in general, specifically changes in the S&P 500 , at least for day-to-day moves. Given the size of cross-border investment flows that smells right- when there's a flight to safety in the US you would expect USD appreciation against all other currencies, & commodities. So perhaps this is only another face of the oil price change, but I wonder.
And there are definite shorter-term range limits and resistance/support points, which isn't all that surprising given some relatively large corporate hedges out there, which often encourage these sorts of patterns. But they aren't long term, as the hedges are steadily replaced at new levels, so maybe adding in a function related to the gap to a rolling average, or perhaps a gap to back-checked max/min?
And yes these all reflect real-market behaviour, in a previous incarnation in FX sales the underlying drivers routinely came up in discussions with corporate, investor & speculative clients all.

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