Dollar Index: Barometer of Global Currency Market

Introduction

To buy any goods and service from the market, you need money; which is mainly either paper form or digital form. Today’s paper or digital currency is the medium of exchange across the globe, which had evolved over centuries from a barter system to a coin system. Each country has developed their own currency to price goods and services in their country. Commencement of international trade and travel resulted in exchange of one currency with another to make the transaction easy. At the same time, an increased international trade and travel made it difficult to deal with different currencies whose value changes based on economic condition of that country. This situation has resulted into evolution of currency basket to smoothen the risk of global currency market.

A currency basket is a set of different currencies with different weightage to represent the overall performance of those currencies. Since currencies of different countries move based on economic indicators of those countries as well as the country of the pegged currency, they showcase different price actions. Hence, it is very important to capture the overall movement of major currencies to have a uniform price action. Hence, currency baskets are formed. The most actively traded and tracked currency basket is the dollar index.

Currency Basket Explained

Indexes serve as benchmark comparisons for a variety of purposes across the financial markets as a notional portfolio of securities. Indices are best investment options for investors as these products will perform collectively of individual constituents within it.

Dollar Index is the most tracked currency basket across the globe by various asset classes such as stock, commodities and bonds as they carry some relation with each other. Dollar index measures the strength of the U.S. Dollar against six major currencies such as Euro (EUR), Japanese Yen (JPY), British Pound (GBP), Canadian Dollar (CAD), Swedish Krona (SEK) and Swiss Franc (CHF). The weightage of each of these currencies are as follows.

Source: https://www.theice.com/publicdocs/futures_us/ICE_Dollar_Index_FAQ.pdf

Above mentioned currencies are the world’s major currencies in terms of volume, and they control more than 60% of the global trade of goods and services. EURUSD is the single largest tradeable currency in the world because of its wide usage and stable economic conditions.

Assessing the Scope of Currency Baskets

Currency baskets are used by equity and commodity market investors to smoothen the risk of individual currencies. When the investors are trading in their own country either equity or commodity, they are priced in that country’s currency. However, whenever investors want to trade in other countries, then they have to trade in that country’s currency. In such a situation, currency baskets will come to their rescue by smoothening the currency risk.

Dollar index—most prominent currency basket—is very useful for global financial market traders to track the performance of global currency market rather than tracking individual country currencies.

Conclusion

A currency basket sets the benchmark for each country`s central bank to fix their exchange rate with the pegged currency. The central banks can reduce exchange-rate fluctuations by using a basket of foreign currencies rather than a single currency. Currency baskets are also used to minimize or avoid the risk of single currency fluctuations. The most actively traded and tracked currency basket is the dollar index. Currency baskets are used by equity and commodity market investors to smoothen the risk of individual currencies.

FAQs

·         How does a currency basket work?

The currency basket is fixing the value of one currency against a few currencies with a calculated weight to smoothen the risk of a single currency. This helps global traders minimize or avoid the single currency risk when trading in different countries. A currency basket captures the collective price movement of all the constituent currencies.

·         What currencies are included in the dollar index?

The dollar index is the most prominent and popular currency basket traders use globally. Dollar index measures the strength of the U.S. Dollar against six major currencies such as Euro (EUR), Japanese Yen (JPY), British Pound (GBP), Canadian Dollar (CAD), Swedish Krona (SEK) and Swiss Franc (CHF).

·         What happens when dollar index increases?

When the dollar index increases, which means strengthening of the U.S. Dollar against major currencies, the value of dollar-denominated goods and services becomes costlier. At the same time, the price of goods and services quoted in other currencies become cheaper. This scenario leads to divergence of money from riskier asset classes to safer asset classes.

·         What happens to USD when inflation is high?

Higher inflation tends to have depressing effective on the value of the country’s currency. In other words, higher inflation reduces the buying power of that country’s currency. Rising inflation tends the central bank to control it by increasing the interest rate. Hence, higher inflation dampens the value of USD against major currencies.

·         Where to track Dollar Index?

You can track dollar index on www.investing.com

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