What Is A Currency Basket?
A currency basket refers to holding different currencies with varied weights as a single currency or asset. The purpose of it is to mitigate the currency risks arising from frequent fluctuations in currency rates while trading or managing foreign transactions. They help create a stable marketplace.
Various currency baskets are used in the global market. The US Dollar Index (USDX) basket has been the most popular one for many years. It comprises the British Pound (GBP), the Canadian Dollar (CAD), the Euro, the Japanese Yen (JPY), the Swedish Krona (SEK), and the Swiss Franc (CHF). Similarly, the Special Drawing Rights (SDR), or the SDR currency basket, is also well-known. It derives value from the US Dollar, the Euro, the Chinese Renminbi, the Japanese Yen, and the British Pound Sterling.
Table of contents
- A currency basket is a collection or group of currencies packed together under a reserve currency arrangement. Each currency is assigned a certain weight, and many currencies are pegged together to make a reserve currency.
- The concept was introduced in 1969 when the IMF created the Special Drawing Rights (SDR). It had 16 currencies.
- To create a basket, the selection of currencies is the first step. Later, weights are assigned based on trade relations between countries and other economic parameters.
- It provides huge benefits to equity traders and investors involved in forex transactions. For example, the European Currency Unit (ECU) supported trading before the Euro came into the picture.
Currency Basket Explained
A currency basket refers to a cumulative group or collection of currencies placed in a basket. It can be linked with the popular idiom Don’t put all your eggs in one basket, indicating how such measures can prevent the problems typically seen when an individual puts all their eggs in the same place.
Here, the currencies with different weights are added to a basket to reduce the risks arising from foreign trade. This strategy aims to protect investors, traders, and businesses from trade shocks in forex transactions. Countries band together, bringing their currencies under one reserve currency (asset) that derives value from each of the currencies that strengthen it. The European Currency Unit (ECU) appeared in the currency basket list before the Euro was introduced. Similarly, the Asian Currency Unit (ACU) was a proposed system that never saw the light of day.
There are two types of baskets: Dual currency and Multi-currency baskets. The former involves only two currencies. The latter has multiple currencies (more than two currencies). Multi-currency baskets are common since multiple currencies are pegged to one currency, offering a more risk-free trading environment and higher flexibility. Dual-currency baskets are rarely used.
Relevant agencies may monitor the performance of these baskets in some regions using a currency basket index. For instance, financial institutions and investors use it for risk management. The USDX is a perfect example to cite here, with different currencies forming the basket.
Each currency in the basket carries a specific weight based on economic indicators, such as the Gross Domestic Product (GDP) and Purchasing Power Parity (PPP), of the country to which the currency belongs. There are certain methods to determine the weights. They are:
- The total value of a country’s GDP compared to the sum of the GDPs of all the nations that help form the basket is considered.
- Another method considers the number of shares held by foreign countries and the frequency of their operations in the country in question.
Origin And History
Currency baskets have been in use since the 20th century. However, certain events influenced their creation and usage. Let us briefly study the timeline of these events:
In 1969, the International Monetary Fund (IMF) introduced the SDR. Its value was pegged to five currencies.
The structure of the currency basket of the IMF was divided in the following manner:
41.9% → US dollars
37.4% → Euros
11.3% → Pound Sterling
9.4% → Japanese Yen
In 1974, the currency basket of the IMF was revised to include 11 more currencies. As a result, the total currencies in the SDR basket went up to 16. The basket structure was:
US Dollars → 42%
Deutsche Mark → 19%
France Franc → 13%
Japanese Yen → 13%
Pound sterling → 13%
In 1981, the total count of pegged currencies was reduced to only five currencies. Consequently, in January 1999, the Euro replaced the Deutsche Mark and Franc. The five currencies are the US Dollar, the Euro, the Chinese Renminbi, the Japanese Yen, and the British Pound Sterling.
This section explains how a currency basket is created. The steps are:
Step #1: Determining the Currencies
The first step in the development of a currency basket involves the currency itself. Investors and regulatory bodies choose currencies based on currency stability, volatility, and liquidity. Countries select the currencies they believe will prove suitable. However, most may prefer the currencies of the countries with which they have trade relations. For example, the United States has extensive trading ties with China, Mexico, Japan, Canada, and Germany. Thus, the US currency basket list may involve the currencies of these countries.
Step #2: Choosing the Appropriate Weights
Once the currencies are selected, the next step is assigning them weights. These weights depend on certain economic factors. A currency that plays an instrumental role in imports or exports tends to receive more weight. Simply put, the higher the trade volume with a certain country, the more important its currency becomes. In addition, the currency’s performance is crucial. Certain factors like inflation and interest rates also influence its performance.
For instance, if China trades extensively with the US, the weightage of dollars will be high. These weights may change as trade relations change. They may also change based on the changes seen in the world economy.
Let us study some examples of currency baskets and discuss the concept in greater detail.
Assume a US-based automobile firm has operations in different countries. Of the various locations, they have branches in Mexico, Japan, and the United Kingdom. So, the management decided to put these currencies under a basket system. In addition, some weights were assigned based on the revenues. For example, if Japan generates more revenue, the weightage would be around 40% or more. Similarly, weights were assigned to Mexico and the UK.
Hence, the entire currency basket’s value changes as the value of each pegged currency changes. The value of each currency not only affects the basket but also impacts every other currency in the basket.
According to a March 2023 report, BRICS countries (Brazil, Russia, India, China, and South Africa) are considering launching their currency basket. During the meeting, Pavel Knyazev, the Russian ambassador, stated that this strategy would work in favor of each country and further their economic interests. Hence, strengthening trade relations and boosting economic growth are key considerations while forming an alliance for establishing a reserve currency.
The following are the possible applications and benefits of currency baskets in the global market:
#1 – Facilitates Risk Management
The currency basket is a tool to reduce the risks involved in foreign transactions. Investors can use this index to divert or manage the risks of fluctuating rates. Plus, they get access or exposure to multiple currencies, which reduces losses during equity trading.
#2 – Dynamic Selection of Currency
Investors can change their investment patterns and structure whenever needed. In other words, they can remove or add the currencies in the basket to suit their trading requirements.
#3 – Currency Valuation – Actual Value
With constant fluctuations, the exchange rate may influence the transaction value. Thus, using the currency basket can help determine the currency’s actual value. In short, it provides an overall view of the performance of the entire basket.
Frequently Asked Questions (FAQs)
China was the latest country included in the IMF’s currency basket. The Chinese currency Renminbi became part of SDR in October 2016. In addition, the 3-year China treasury bonds were also added to determine the interest rates on SDR.
The currency basket that involves six currencies is the USDX. It includes the British Pound, the Euro, the Swiss Franc, the Japanese Yen, the Canadian Dollar, and the Swedish Krona.
Investors can create a basket or invest in a currency basket index. They can create personalized baskets using their choice of currencies. Depending on the position an investor plans to assume in a given market, they will be required to buy or sell currencies. They can trade index futures in the market to mitigate losses.
This has been a guide to What is Currency Basket. Here, we explain it with examples, its usage, how to create it, origin, and history. You can learn more about it from the following articles –