Trade Weighted U.S. Dollar Index

The American dollar is used as the standard unit of currency in world markets for commodities such as gold and petroleum, it also the world’s foremost reserve currency.

16th September 2013

The U.S. dollar slipped against its major counterparts on Friday as the U.S. added fewer jobs than expected in August, with downward revisions in the June and July employment figures.  The American dollar is used as the standard unit of currency in world markets for commodities such as gold and petroleum, it also the world’s foremost reserve currency. A reserve currency is a currency held in huge quantities by most of the governments as a means of international payment, while the reserves consisted of gold and silver, the Bretton Woods System expanded acceptable reserves to include the U.S. dollar other currencies. It is also held in order to support the value of national currencies, but the U.S. dollar will not be the world’s reserve currency for ever. The Euro is becoming hugely popular despite set back during the sovereign debt crisis which weakened the common currency immensely.  In this article, let us discuss on the two most important indexes used in the U.S. to determine the exchange rate of the dollar with its counterparts from rest of the world, let us also see how the U.S. dollar Index is different from the Federal Reserve’s Trade Weighted Dollar Index.

What is an exchange rate and why is it used?

An exchange rate is the current market price for which one currency can be exchanged to another. For instance, if the Euro exchange rate for the U.S. dollar stands at $1.3, one euro can be exchanged for 1.3 U.S. dollars. Exchange rates predict the competitiveness of a country with another and influence the trade and business of the particular country, currency exchange rates are among the most analysed and forecasted indicators in the world. It is determined by the level of supply and demand in international markets and also the prevailing economic situation of the countries. The currency markets in the world are the most liquid with a daily turnover of close to $ 2 trillion.

What does the U.S. Dollar Index measure?

The U.S. Dollar Index is a geometric mean of six major world currencies weighted against the U.S. dollar which measures the performance of dollar against the group of these six world currencies mentioned below.Since the U.S. trades more with certain countries than others. U.S. companies will have more risk exposure to the currencies of those countries. Therefore, the dollar index weights each currency to reflect that risk as follows:

The Euro is weighted more heavily than all other countries combined, which means that when the euro changes it dictates what happens to the USDX unless other currencies move in the opposite direction to compensate for it. For example, if the Euro loses value, the dollar’s value as measured by the USDX rises. The only exception would be if all other currencies rose enough to counterbalance the euro’s fall.

The USDX is an index since it compares the dollars to different currencies; this is different from all other exchange rates, which compares only two currencies at a time. The USDX index started at 100 on March 1973 when it was first created. Therefore, the USDX current value tells you the present change of the dollar since its beginning on March 1973. For example, on September 13^th 2013, the USDX closed at 81.63, which means the dollar has lost 18.37 percent of its value since 1973, when the USDX was 100.

Why is the USDX important?

The USDX is a very valuable analytical tool for any trader who is trading the forex, it also provides the relative strength of the U.S. dollar even when market outlook for the U.S. dollar is unclear.

Federal Reserve Trade Weighted Dollar Index

Trade weighted currency index is a weighted average of a basket of currencies that reflects the importance of a country’s trade (exports and imports) with other countries. In some cases, a trade weighted currency index is also taken as a crude measure of a country’s “international competitiveness”.

Trade Weighted Dollar

Investopedia defines “Trade Weighted Dollar” as a measurement of the foreign exchange value of the U.S. dollar compared against certain foreign currencies. Trade weighted dollars give importance or weight to currencies most widely used in international trade, over comparing the value of the U.S. dollar to all foreign currencies. Since the currencies are weighted differently, changes in each currency will have a unique effect on the trade weighted dollar and corresponding indexes.

Differences between the two indices

The USDX had a fixed composition – a unique feature among currency indices, it has changed only once since its inception in 1973 and that was when then Euro was launched in January 1999, replacing European currencies.  The net representation of the European legacy currencies in the USDX remained fixed at 57.6 percent. The Federal Reserve realized the bias of the USDX and created a trade weighted index that accurately reflected the dollar’s strength against the currencies of major U.S. trading partners. The currencies selected represented the 26 countries which the U.S. trades more frequently, unlike the USDX, this index is updated annually to reflect current trading exposures, the broad currency index includes the Euro area, Canada, Japan, Mexico, China, U.K., Taiwan, Korea, Singapore, Hong Kong, Malaysia, Brazil, Switzerland, Thailand, Philippines, Australia, Indonesia, Israel, Australia, Indonesia, India, Israel, Saudi Arabia, Russia, Sweden, Argentina, Venezuela, Chile and Colombia.

The main difference between USDX and the trade weighted dollar index is the basket of currencies used and their relative weights. The trade weighted index includes countries from all over the world, including some developing countries, the USDX is a subset of the broad based trade weighted index. Unlike the U.S. Dollar Index (USD) the Trade Weighted Dollar Index lacks a baseline, rather the index is quoted in terms of currency units per U.S. dollar.