What is Trade-Weighted Exchange Rate?
The Trade-Weighted Exchange Rate is a ‘complex measure’ of an exchange rate. It involves the measurement of the strength of a country’s currency weighted by the amount of trade with each country.
The Trade-Weighted Exchange Rate is largely influenced by the degree of trade carried out by one country with another. The greater the amount of trade between two countries, the larger is the effect of a change in either currency on their respective trade-weighted exchange rates.
The trade-weighted exchange rate is calculated by taking into consideration the weights of shares of different currencies in trade of a country whose trade-weighted exchange rate is to be calculated. Let us take the example of New Zealand.
The above graph depicts New Zealand’s trade-weighted index, taking into account 17 currencies of different countries depending on their trade with it. The major trading partners of New Zealand are Australia, Japan, USA, the UK, and Germany. The trade share of Australia, Japan, USA, the UK, and Germany are 22%, 14%, 13%, 6%, and 4%, respectively.
Calculation of Trade-Weighted Exchange Rate
- Include the currency of the top five countries with which a country maintains maximum trade relations. In the case of New Zealand, it will be Australia, Japan, USA, the UK, and Germany.
- Weights are assigned to each country depending on the level of its trade with New Zealand, i.e. the exports and imports of the five countries mentioned above with New Zealand.
- The index is calculated as the geometric mean using the following formula:
|CURRENCY||TRADE WEIGHT||EXCHANGE RATE|
|Current Period||Base Period|
|(24 September 2017)||(30 May 1997)|
In this case, TWI will be calculated as follows:
= (0.93/0.9013)0.2073 x (82.21/80.4348)0.0635 x (0.73/0.6910)0.1398 x (0.54/0.4216)0.0456 x (1.29/1.0822)0.0598 x 100(assumed to be 100)
= 1.0065 x 1.001 x 1.008 x 1.011 x 1.011 x 100
Challenges to Trade-Weighted Exchange Rate
In earlier times, Trade-Weighted Exchange Rate was an effective tool in measuring the exchange rate as most international transactions entered into by countries were on account of trade. However, with the increase in globalization, the global economy is witnessing a rapid increase in capital flows. Thus, taking into account trade only proved to be an insufficient measure.
Apart from that, there is a chance of inaccurate measurement of exchange rate on account of undervaluation of trade between countries. Some trade may go unaccounted for by Customs officials because traders try to evade duties on goods traded. This proves as a major drawback in the use of trade-weighted exchange rate.
Adding to the above, trade-weighted exchange rate does not take into consideration the demand for the currency as an international reserve asset.