FX | Global | Monetary Policy & Inflation | US
What Are Currency Indices?
- By Richard Jones
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- 4 min read
Summary
- Currency indices traditionally measure the value of a specific currency against a basket of other currencies.
- Currency indices are mostly constructed on a trade-weighted basis and are used by central bankers and other policymakers to gauge the value of their domestic currency against the others.
- Investors can also use currency indices, both as a hedging tool and for speculation.
Introduction
Currency indices are a critical tool for foreign exchange (FX) market participants, yet are not widely talked about or understood.
Broadly defined, they are a measure of a specific currency’s value against a basket of other currencies. They are mostly constructed on a trade-weighted basis and are often referred to as trade-weighted indices (TWIs).
TWIs are especially useful for central banks in assessing the strength of their currency against a basket of other currencies, weighted by importance of the other currencies on the central bank’s domestic economy.
Investors and traders can also use currency indices for both hedging and speculation. For example, the most widely traded currency index is the USD Dollar Index (DXY), and many traders use the DXY to express a view on the US dollar (USD).
In this article, I discuss a select few indices based on my personal experience of trading and writing about FX markets since the mid-1990s.
The US Dollar Index (DXY)
The DXY is a futures contract that trades on the ICE Exchange. It is widely recognised as the benchmark index for USD. Futures trading in the DXY began in 1985, with options on those futures introduced in 1986.
The index measures the value of USD against a basket of currencies from the United States’ top six trade partners as measured in 1973: the euro-area, Japan, the United Kingdom, Canada, Sweden, and Switzerland.
The DXY is composed as follows: euro (57.6%), Japanese yen (13.6%), British pound sterling (11.9%), Canadian dollar (9.1%), Swedish krona (4.2%), and the Swiss franc (3.6%).
The US Federal Reserve (Fed) developed the dollar index in 1973 to provide an external bilateral trade-weighted average value of USD as it freely floated against global currencies. The weights in the DXY have been held constant since inception.
The weights in the Fed’s trade-weighted dollar index (TWI) have changed since 1973 but, irrespective of changes in the weighting and composition of the Fed’s TWI, the current ICE futures contract and cash index matches the Fed’s index very closely.
Other USD Indices
Although the DXY is the best-known and most widely used currency index, it can be criticised as a basket for being composed exclusively of other developed market (i.e., G10) currencies.
Those market participants interested in a broader basket of currencies in a USD index should look at the Bloomberg USD Index (BBDXY).
Bloomberg describes the BBDXY as having ‘a dynamically updated composition’ representing ‘a diverse set of currencies that are important from trade and liquidity perspectives.’
Moreover, Bloomberg claims the BBDXY ‘provides a better measure of the US dollar compared to other indices that do not update their composition and comprise of a handful of currencies with concentrated weights.’
At present, the BBDXY’s weightings are as follows: EUR (31%), JPY (13.5%), CAD (11%), GBP (11%), MXN (9.2%), CNH (7%), CHF (5%), AUD (4.8%), KRW (3.3%), INR (2.7%), and TWD (2.1%).
As that list shows, the BBDXY provides a broader cross-section of currencies within its basket than the DXY, with a mix of G10 and other currencies. It is a robust alternative to the DXY.
The Fed also maintains a broad range of USD indices, both nominal and real (more on real exchange rate indices below). Included among these numerous indices, the Fed publishes a nominal Broad Dollar Index on both a daily and monthly basis, in addition to a real Broad Dollar Index monthly.
Real Effective Exchange Rate (REER)
Another important concept to consider when discussing currency indices is the real effective exchange rate (REER).
The International Monetary Fund (IMF) says REER ‘is the real effective exchange rate (a measure of the value of a currency against a weighted average of several foreign currencies) divided by a price deflator or index of costs.’
The IMF also says ‘an increase in REER implies that exports become more expensive, and imports become cheaper; therefore, an increase indicates a loss in trade competitiveness.’
The IMF also provides REER data through the International Financial Statistics (IFS) dataset portal here.
REERs are an important tool for central bankers and other policymakers. REERs are an effective indicator of a nation’s international competitiveness in comparison with its trade partners.
Other Non-USD Trade-Weighted Indices (TWIs)
In addition to the DXY, BBDXY, and REERs, there are other noteworthy TWIs.
My favourites are the Deutsche Bank TWIs, which are available for both developed and emerging market currencies. Disclaimer here – I worked at Deutsche Bank when these indices were developed, although I was not part of the team that developed them.
I am partial to them, however, because they are an effective way to gauge a currency’s value against the currencies of its most important trade partners. Additionally, these indices appeal because many of them are tradeable.
Purchasing Power Parity (PPP)
PPP is an important theory of currency valuation, one that many of you will have learned in your economics or business courses at university.
PPP can probably best be described as ‘the law of one price.’
The OECD definition of PPP is that ‘purchasing power parities are the rates of currency conversion that try to equalise the purchasing power of different currencies, by eliminating the differences in price levels between countries.’
The OECD also says that ‘the basket of goods and services priced is a sample of all those that are part of final expenditures: final consumption of households and government, fixed capital formation, and net exports.’
PPP for any currency is generally measured against USD.
The Big Mac Index
My favourite measure of PPP is The Economist’s Big Mac Index (BMI). It is a very simplified way of looking at PPP but is quite effective.
The BMI is updated regularly and, as the name suggests, it measures the cost of a Big Mac burger at various McDonalds’ restaurants across the world.
It then, using the law of one price, determines the extent of over- (or under-) valuation that exists for a wide range of currencies.
At present, for example, the Swiss franc (CHF) is the world’s most overvalued currency in the world, with a Big Mac costing 35.4% more in Switzerland than in the US.
In contrast, the Egyptian pound is the world’s most undervalued currency, with a Big Mac 65.6% cheaper in Egypt than in the US.
PPP’s Shortcomings
It is very tricky to use PPP as an input for trading decisions.
PPP is an academic theory and, while robust and accurate, it is hard to trade it because any currency can stay over- (or under-) valued for a very long time, and certainly beyond almost every portfolio horizon.
For example, the Swiss franc has been overvalued against almost every currency in the world since at least the mid-1990s, when I started trading rates and FX.
On the franc, I am still waiting for it to be in equilibrium (and it might never get there in my lifetime). Basing an investment or trading decision on a metric like this, therefore, is impractical.
Still, I find PPP an interesting gauge of longer-term currency valuations. And, at the margin, it could be used as a supplementary input for trading decisions.
For example, if you thought that the euro was due to rally, based upon analysis of a bunch of criteria, and PPP showed the euro to be materially undervalued, PPP would reinforce this analysis and give you additional confidence in your thesis.
Conclusion
Currency indices are an important analytical tool for policymakers, as indices provide a ready reckoner about the valuation of a currency relative to its trading peers.
Given that currency valuations are important inputs for monetary policy, understanding how central banks look at currencies is critical.
Currency indices can also be an effective tool for speculators and hedgers. The DXY, for example, is a broadly traded currency index, which is accessible and liquid.
And, while PPP is not tradeable in a practical way, it can be a powerful supplemental input for any analysis for trading FX.