A Brief Overview
Different countries and regions have different currencies that operate within them and allow for the sale and purchase of goods. Have you ever found yourself wondering how a country determines its own currency exchange rate? This article seeks to shed light on the same by looking at all that a currency basket entails.
Defining a Currency Basket
A currency basket can be understood to be a set comprised of a number of currencies that each hold different weightings. A currency basket is employed to determine the market value of a separate currency. This practice is often referred to as a currency peg. A forex trader may take up basket orders such that they can partake in the trade of a number of currency pairs in a single go.
Currency cocktail is a colloquial term used to refer to a currency basket.
Examining the Scope of a Currency Basket
The prevailing monetary authority within a country such as its central bank may make use of a basket of currencies in the form of a reference such that it can determine its own currency’s exchange rate. This is often the case in the matter of pegged currencies.
With the aid of a basket of foreign currencies, as opposed to being pegged to a sole currency, the monetary authority of a country can help bring down fluctuations pertaining to the exchange rate.
Contracts may also employ the aid of a currency basket in order to minimize the risk associated with currency fluctuations. In order to better acquaint yourself with currency baskets, consider the Asian currency unit in addition to the European currency unit (that was swapped for the euro) which serve as viable currency basket examples. The US dollar index (or USDX), however, continues to hold court as the most popularly recognized currency basket.
This US Dollar index (or USDX) began in 1973. Presently it constitutes six currencies that are the British pound (GBP), the Canadian dollar (CAD), the euro, the Japanese Yen (JPY) the Swedish krona (SEK) and the Swiss franc (CHF). Of these, the euro constitutes the biggest player within the index and accounts for 57.6 per cent of the basket. The remaining currencies hold weights amounting to 13.6 per cent in the case of JPY, 11.9 per cent in the case of GBP, 9.1 per cent in the case of CAD, 4.2 per cent in the case of SEK and 3.6 per cent in the case of CHF.
The 21st century has borne witness to this index reaching a high of 121 that occurred during the tech boom and a low of 71 in the time leading up to the Great Depression.
Assessing the Scope of Currency Baskets
Equity investors that are exposed to a number of varied countries will make use of a currency basket such that they can reduce the risk they expose themselves to. Primary investment strategies of such investors lie within the realm of equity markets. That being said, they are unlikely to want to run into major losses when they invest in foreign equity markets owing to fluctuations in the currency. The same logic holds true for bondholders.
On the flip side, however, currency traders that occupy a more expansive view of a single currency are likely to purchase that single currency as opposed to a wide variety of varying currencies. Take for instance the following example. Traders that have a bullish attitude towards the U.S. dollar may make use of the USDX to highlight this opinion. Traders and investors have the freedom to create their own currency baskets made up of different weightings keeping in mind the strategy they seek to employ.
It is important to understand that the weights of currencies that prevail with a basket trade and outlined by the trader or in accordance with a program or strategy. In the following example, a trader seeking to amass a U.S. dollar position may decide they need to sell the EUR/ USD, AUD/ USD and GBP/ USD and can instead focus on purchasing the USD/ JPY, GBP/USD and EUR/USD. The remaining 60 per cent of the funds are divided between the remaining four currency pairs which each hold 15 per cent.
Regardless of the currency basket under consideration, currency components are selected in accordance with the purpose of the basket. Investors that seek to limit the currency risks they experience may select stable currencies that are liquid. On the flip side, investors that seek to arrive at a value for their currency may select currencies in accordance with those that are most related to the domestic currency.
The means by which the ratio for each currency or relative weight is selected is made keeping in mind the use the currency basket serves. Investors may select a basket of currencies they view to be stable as their own objective is to reduce currency risk. Currency performance can take into account a number of factors ranging from risk events, interest rates and inflation among others.
In order to help with valuation, weightings are in sync with the manner in which the currencies are selected. In terms of the aforementioned USDX for instance, the weights of the currencies considered are made as per the various countries’ level of importance of trade with the United States. Owing to this fact that Europe serves as the United States’ largest trade partner owing to which it occupies 57.6 per cent of the currency basket.
To wrap up, currency baskets can be employed to curtail currency risks and to help determine the value of a currency. Currency baskets can be altered with ease by simply adding or removing currencies and adjusting the weights in accordance to the needs that prevail.