- Date : 30/09/2023
- Read: 3 mins
Investors use tools like Currency Basket to determine the potential value of currencies and decide their ForEx Trading strategies.
Investors who trade in currencies to take advantage of the fluctuating currency values with respect to one another are known as ForEx traders. A Currency Basket is a portfolio consisting of several prominent foreign currencies selected by an investor to keep a note of the currency values and determine their future ForEx Trading Strategies.
Also Read: Benefits of Portfolio Diversification
Currency Baskets are used to monitor the fluctuations in the currency exchange rates of currencies you wish to trade in.
Currency Baskets are colloquially termed as currency cocktails by investors.
Currency Baskets was first introduced as a concept in 1969 when the IMF created a basket called Special Drawing Rights (SDR).
The first step to create a Currency Basket is to select the currencies, followed by assigning weights to the currencies based on the economic relations between the countries.
What is a Currency Basket?
Currency Baskets are a collection of currencies placed in a portfolio to mitigate exchange-rate fluctuation risks and give the investor an intimation about the way a country's currency is trending. Countries band together to create these baskets to act as a reserve currency that derives its value from the involved currencies.
How are the Weights Determined?
Each Country in the basket has its currency weighted based on economic indicators such as the Gross Domestic Product (GDP) and Purchasing Power Parity (PPP). They can be used in these ways to determine the weights:
- The value of a country's GDP with respect to the other countries in the basket's GDP combined.
- Count the number of shares held by a country and the frequency of their economic activity.
Also Read: Purchasing Power Parity
Common Examples of a Currency Basket:
- European Currency Unit - proposed basket of European currencies, later replaced by the Euro.
- Asian Currency Unit - proposed a basket of prominent Asian currencies.
- US Dollar Index (USDX) - proposed basket of six prominent currencies from around the world, namely, Euro, Japanese Yen, British Pound, Canadian Dollar, Swedish Krone and Swiss Franc. The euro is the biggest component of the USDX, accounting for about 58% (technically 57.6%). The remaining currencies in this index are weighted as JPY (13.6%), GBP (11.9%), CAD (9.1%), SEK (4.2%), and CHF (3.6%).
Uses of a Currency Basket:
- Determining Currency Exchange Rates - A country's monetary authorities use currency baskets to peg their currency's exchange rates.
- Reducing Exchange-Rate Fluctuation Risks - ForEx Trader's use currency baskets to mitigate the exchange-rate fluctuation risk.
Investors can choose to invest in a currency basket index or create a new currency basket with a direction in mind, whether it be bearish or bullish.
Also Watch: Forex Weekly Fundamental Analysis
Disclaimer: This article is intended for general information purposes only and should not be construed as investment or legal advice. You should separately obtain independent advice when making decisions in these areas.
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