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A currency basket is a portfolio of various currencies that are weighted against a chosen currency. The weighted value can be used to determine the market value of a chosen currency or by investors to reduce currency risk.
A currency basket is a portfolio of various currencies with different weightings. It is useful for reducing foreign exchange volatility and valuing a chosen currency.
Choosing currencies and their relative weights are subject to the purpose of the currency basket.
The contents of the basket can be adjusted to reflect changes in exchange rates and expectations over time.
Making a Currency Basket
For any given currency basket, the currency components are chosen according to the purpose of the basket. Investors looking to mitigate their currency risk may choose stable, liquid currencies. On the other hand, investors looking to value the chosen currency may choose criteria related to the country of the currency.
For example, the currency basket on the US dollar (USDX) includes the currencies of the biggest trading partners of the U.S. Any number of criteria could be used at the judgment of the basket creator.
The process of choosing the ratio of each currency or relative weight is also subject to the purpose of the currency basket. Investors may choose a basket of currencies they believe are stable since their objective is to minimize currency risk. The outlook on currency performance can be based on several factors, such as inflation, interest rates, risk events, and more.
For valuation, weightings are aligned with how the currencies are chosen. Referring back to the USDX, the weights of the currencies are assigned according to the various countries’ importance of trade with the U.S. Since Europe is the U.S.’ biggest trade partner, the USDX weighs the euro at 57.6% of the currency basket.
Using a Currency Basket
Reducing Currency Risk
Investors abroad are continually exposed to foreign currency risk. This means that on top of the performance of their asset, the conversion back into the home currency can erase profits or even worsen losses if the exchange rate proves to be unfavorable. To reduce foreign currency exposure, investors can create a currency basket to generate diversification. Doing so takes out the idiosyncratic (diversifiable) risk associated with investing with a single currency.
As expected, currencies within the basket may also move unfavorably; however, the smaller weights and diversified currencies with low correlation will have less of a negative impact than only holding one currency.
Valuation using a currency basket is built on the basis that a currency can derive value by its worth to other currencies. Under the gold standard and the subsequent Bretton Woods system, all currencies were pegged to gold and the US dollar, respectively. Pegged currencies are easy to value because their value moves with the asset it is fixed to.
Following the dissolution of the Bretton Woods system, many global currencies decided to adopt a floating rate. The floating rate system creates more uncertainty because each floating currency is subject to multiple factors that affect its movements. On the other hand, under a fixed rate, all currencies moved with the fixed asset. Currency baskets are useful for valuing currencies under a floating rate which removes biases inherent with comparing individual currency pairs.
For example, if we compare the USD/CAD exchange rate, we may find that the USD appreciated against the CAD over a certain time horizon and conclude that the USD rose in value. However, it turns out that the USD depreciated against most other currencies, actually declining in value overall.
Because the CAD depreciated even more against other currencies, the larger depreciation of the CAD relative to the smaller depreciation of the USD looks like a rise in the USD’s value. A currency basket provides an aggregate view of performance, eliminating wrong conclusions associated with comparing single currency pairs.
Adjusting Currency Baskets
Currency baskets can be easily adjusted by adding or removing currencies and adjusting weights according to needs. Interestingly, the USDX only made one adjustment since its inception in 1973, despite currencies such as the Swedish krona’s and the Swiss franc‘s increasingly small role in the US trades. The newer trade-weighted US index (or broad index) may be a better interpretation of the US dollar’s value since its weightings and currencies are updated yearly.
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