What Is a Currency Basket?
A currency basket is comprised of a mix of several currencies with different weightings. It is often used to set the market value of another currency, a practice commonly known as a currency peg. Colloquially, a currency basket is also referred to as a currency cocktail.
Understanding Currency Baskets
A currency basket is commonly used in contracts as a way of avoiding (or minimizing) the risk of currency fluctuations. The European currency unit (which was replaced by the euro) and the Asian currency unit are examples of currency baskets. However, the most well-known currency basket is the U.S. dollar index (USDX).
The U.S. dollar index started in 1973, and today is a basket of six currencies—the euro, Japanese yen, British pound, Canadian dollar, Swedish krona, and Swiss franc. The euro is, by far, the largest component of the index, making up almost 58 percent (officially 57.6%) of the basket. The weights of the rest of the currencies in the index are—JPY (13.6%), GBP (11.9%), CAD (9.1%), SEK (4.2%), CHF (3.6%). During the 21st century the index has reached a high of 121 during the tech boom and a low of 71 just prior to the Great Recession.
- A currency basket is comprised of a mix of several currencies with different weightings.
- A currency basket is often used to set the market value of another currency.
- Equity investors who have exposure to different countries will use a currency basket to smooth risk.
Usage of Currency Baskets
Equity investors who have exposure to different countries will use a currency basket to smooth risk. Their core investment strategies are in the equity markets, but they do not want to incur substantial losses when investing in foreign equity markets due to currency fluctuations. The same can be said for bondholders.
On the other hand, currency traders who have a broad-based view of a single currency will choose to own that currency against a variety of different currencies. For example, traders that are bullish on the U.S. dollar could use the USDX to express this view. Traders and investors can build their own currency baskets with different weightings depending on their strategy.