Trade-Weighted Exchange Rate

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21 Aug, 2024

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Trade-Weighted Exchange Rate Meaning

The trade-weighted exchange rate is the measure of a nation's currency exchange rate against that of another country based on the number of trades they involve in with each other. The primary purpose of this rate is to determine how a currency exchange rate changes on par with other currencies and help assess how strongly a currency stands in the global market.

The trade-weighted exchange rate index is an important economic indicator for the nation. There are certain weights assigned to different currencies. They help in determining the real value of domestic and international trade. Plus, it is helpful in imports and exports. However, the degree of trade may differ, causing an impact on the real trade-weighted exchange rate.

Trade-Weighted Exchange Rate Meaning

Trade-weighted exchange rate refers to a measure of a country's currency value relative to a basket of other currencies, weighted according to each currency's importance in that country's international trade.
The weights assigned to currencies in this exchange rate are based on their significance in a country's trade with different trading partners.
The trade-weighted index comprehensively represents a nation's currency performance and impact on trade flows.
Unlike bilateral exchange rates involving only two currencies, it considers multiple currencies to provide a broader perspective on currency performance in international trade.

Trade-Weighted Exchange Rate Explained

The trade-weighted exchange rate is a weighted average of the home (domestic) currency with the foreign currencies. Here, every weight is assigned by the share held by the currency in the trade. Thus, more trade results in a more significant effect on the currency traded. Similarly, a minor trade cannot influence the real trade-weighted exchange rate. For example, using the US dollar in European countries will see an appreciation in its value. As a result, the weight assigned to it will also be heavy.

This index focuses on applying weights to the currencies involved in the trade. These weights can differ from nation to nation. They can be export-based, import based, or total-external-based. Also, to calculate the real trade-weighted exchange rate index, the geometric mean is used. The weighted average method gives an accurate overview of the currency's value compared to the traded foreign currency. It is vital to note that arithmetic mean is not used as it does not give a relative importance to each traded currency. In addition, it ignores the volume involved in that particular trade.

Depending on the scaling and usage factor, the weights are assigned. A nation with higher use in international trade will have a higher weight allocated. Likewise, the less-traded currency will have the least weightage in the calculation.

A US dollar trade-weighted exchange rate is also known as the Broad Index. Since its creation in 1973, twenty-six currencies have been under this basket. It includes the Japanese Yen (JPY), European Euro (EUR), Canadian dollar (CAD), British Pound (GBP), Swiss Franc (CHF), Swedish krona (SEK), and more.

Formula

Let us look at the formula to have a better understanding of the concept:

Examples

Let us look at the examples of how to calculate trade-weighted exchange rate using the mentioned formula above:

Example #1

Suppose four countries are in trade relations with the United States. It includes Japan, Germany, Mexico, India, and Canada. Each country involves either import or export with the domestic nation. So, with the help of the formula, the US performs the calculation. Let us look at it:

The following schedule mentions the countries along with the currencies and base period. Here, the base period remains to be 1997.

Currencies	Weights	Exchange rate
		Current Year(2023)	Base Year (2000)
Japanese (Yen)	0.8943	139.25	107.80
Germany (Euro)	0.5331	0.94	0.94
Mexico (Peso)	1.0887	56.13	9.46
India (INR)	0.2345	82.51	43.50
Canada (CAD)	1.2566	1.34	1.4886

Calculation:

Trade-Weighted Exchange Rate = 100xΠe_iteiowit X IND

= (139.25/107.80)^0.8943 x (0.94/0.94)^0.5331x (56.13/9.46)^1.0887x (82.51/43.50)^0.2345x (1.34/1.4886)^1.2566x 100

= (2.118) x (0.9715) x (4.8611) x (34.06) x (0.8146) x 100

= 277.51 x 100

= 27,751.

Example #2

Federal Reserve Bank of Kansas City examined various scenarios related to the trade-weighted exchange rate. One of the scenarios they considered was a "no change" scenario, where they assumed that the trade-weighted exchange rate would remain constant for the remainder of 2022 and throughout 2023.

Another scenario they analyzed was an "appreciation" scenario, in which they anticipated a moderate increase in the value of the US dollar by 5 percent until the end of 2023. Additionally, they explored a "depreciation" scenario, where they projected a slight decrease in the value of the US dollar by 2.9 percent until the end of 2023, based on a benchmark known as purchasing power parity.

Bilateral vs Trade-Weighted Exchange Rate

Although bilateral exchange and trade-weighted exchange rate involves FOREX (foreign exchange), the currencies involved differ. So, do their differences. Therefore, let us look at their differences:

Basis	Trade-Weighted Exchange Rate	Bilateral Exchange
Meaning	It refers to assigning weights to different currencies involved in a particular trade.	As the name suggests, a bilateral exchange involves two currencies.
Purpose	To allow weights as per the importance of currencies in international trade.	To calculate the exchange rate between two countries in a particular trade.
Type of exchange	Multilateral (many currencies)	Bilateral (only two currencies)
Example	USD/GBP, USD/JPY, USD/CAD, … n.	A perfect example of bilateral exchange is dollars and euro (USD/EUR).

Frequently Asked Questions (FAQs)

1. Can the trade-weighted exchange rate fluctuate over time?

Yes, it is subject to fluctuations caused by various factors, such as alterations in the relative values of the currencies included in the index and changes in a country's trade dynamics. Economic indicators, disparities in interest rates, geopolitical developments, and market sentiment can all lead to volatility and variability over time.

2. What is the trade-weighted real effective exchange rate?

It is a common category of effective exchange rate index involving multiple currencies. It also takes the weighted average of the exchange rates to the domestic currency. And to determine their weight, their share in the global trade is noted. It also adjusts the rates as per the inflation rate in the country.

3. What is the difference between a real effective exchange rate (REER) and a trade-weighted exchange rate?

Although REER and trade-weighted exchange rates are too similar, they offer different perspectives. The REER takes into account the relative as well as nominal rates adjusting to the inflation levels. However, its primary concern is also to include inflation levels. In contrast, trade-weighted exchange rates only consider the exchange rates of countries.