What is a Currency Basket and How Does it Work?

Key Highlights

• A currency basket is a portfolio of multiple currencies with different weights.
• Selecting currency and its weight depends on the purpose of the basket.
• The government uses the basket to determine the value of its currency.
• An investor can use a mix of currencies to avoid losing money when the value of the currency fluctuates.

Defining Currency Basket

A currency basket is a set of multiple currencies that each hold different weights. A currency basket determines the market value of a separate currency. Often, this practice is called a currency peg. A forex trader may take up basket orders so they can trade a number of currency pairs in a single go. Additionally, currency cocktail is a colloquial term for a currency basket.

Scope of Currency Basket

The central bank uses a mix of different currencies to figure out the value of its own currency. This helps keep their currency's worth stable and not change too quickly.

People and businesses also use this mix of currencies in their contracts to avoid losing money when currency values change. The Asian and European currency units are one of the examples that were swapped for the euro. But the most famous mix of currencies is the US Dollar Index (USDX), which started in 1973.

The USDX includes six currencies: the British pound (GBP), the Canadian dollar (CAD), the euro, the Japanese yen (JPY), the Swedish krona (SEK), and the Swiss franc (CHF). Among them, the euro is the most important, making up about 57.6% of the mix. The others have smaller roles: JPY is 13.6%, GBP is 11.9%, CAD is 9.1%, SEK is 4.2%, and CHF is 3.6%. In the 21st century, the USDX reached its highest point, 121, during the tech boom and its lowest point, 71, before the Great Depression.

Assessing the Scope of Currency Baskets

Investors who trade equities in different countries use a mix of currencies to lower their risk. They mostly invest in equity markets. They don't want to lose a lot of money because of currency changes when they invest in foreign markets. This is also true for people who hold bonds.

On the other hand, currency traders who have a strong opinion about a single currency prefer to buy that currency instead of many different ones. For example, traders who think the U.S. dollar will do well might use the USDX to show their opinion. Traders and investors can choose which currencies to include in their mix based on their strategy.

It's important to know that the amounts of each currency in a mix can be decided by the trader or a program based on their strategy. For instance, a trader who wants more U.S. dollars might decide to sell the EUR/USD, AUD/USD, and GBP/USD and instead buy the USD/JPY, GBP/USD, and EUR/USD. The other 60% of their money is split among four other currency pairs, each with 15%.

Selecting Basket of Currencies

When creating a currency basket, the choice of which currencies to include depends on the basket's purpose. If investors want to reduce the risk associated with currency changes, they may select stable and widely used currencies. Conversely, if they want to assess the value of a specific currency, they might consider factors related to the country using that currency.

For instance, the US Dollar Index (USDX) includes the currencies of the United States' major trading partners, and the criteria for selecting these currencies can vary based on the creator's judgment.

The process of determining how much importance each currency should have, or their relative weights, also depends on the basket's purpose. Investors aiming to minimize currency risk may prefer a basket with stable currencies. Assessing currency performance can involve factors like inflation, interest rates, and risk events.

For example, in the USDX, the weights of currencies are decided based on the trading significance of various countries with the United States. Since Europe is the biggest trade partner of the U.S., the euro makes up 57.6% of the currency basket.

Conclusion

A basket of currencies is a set of multiple currencies that each hold different weights. The central bank uses a basket of currencies to figure out the value of its currency. Moreover, it is helpful for people and businesses to avoid losing money when currency values change. The selection of a currency basket depends on the basket’ purpose. Moreover, determining how much importance each currency should have also depends on the basket's purpose.