Various weightings of other currencies grouped together in relation to a basket currency. Sometimes used by currencies to fix their rate, often on a trade-weighted basket.
Understanding Currency Baskets
A country's monetary authority, such as its central bank, may use a basket of currencies as a reference to set its currency exchange rate, such as in the case of a pegged currency. By using a basket of foreign currencies, the monetary authority can lower exchange-rate fluctuations rather than pegging to just a single currency.
A currency basket is also 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 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 most significant 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 before the Great Recession.
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 due to currency fluctuations when investing in foreign equity markets. The same can be said for bondholders.
On the other hand, currency traders who have a broad view of a single currency will choose to own that currency against various currencies. For example, bullish traders on the U.S. dollar could use the USDX to express this view. Traders and investors can build their currency baskets with different weightings depending on their strategy.
The weights of currencies in a basket trade are determined by the trader or according to a strategy or program. For example, if a trader wants to accumulate a U.S. dollar position, they may sell the EUR/USD, GBP/USD, and AUD/USD, as well as by the USD/JPY, USD/CAD, USD/CHF. They put 20% of the funds into both the EUR/USD and GBP/USD. The other 60% of the funds are split between the other four currency pairs, with 15% each.