A currency basket is a portfolio of several currencies and weightings towards a base currency. Following the end of the gold standard in 1971, leading economies began floating their currencies by 1973. Emerging, frontier, and small economies started to peg their currencies to major market economies, primarily the US Dollar and British Pound. It resulted in concentrated risk and exposure to one currency, and monetary authorities opted to peg their currencies against a basket of currencies essential to their economy.
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Diversification and expansion of global trade spurred the usage of currency baskets. Per data from the International Monetary Fund (IMF), by 1985, 63 countries attempted usage of a currency basket, and 43 used one. Over the 35 years, usage of currency baskets by governments contracted, and by 2019, only eight countries relied on them.
Which countries use a currency basket?
- Botswana (SDR)
- Libya (SDR)
- Syria (SDR)
- Morocco (Euro and USD)
- Fiji (undisclosed)
- Kuwait (undisclosed)
- Singapore (undisclosed)
- Vietnam (undisclosed)
What is a Basket of Currency?
A currency basket, or a basket of money as some falsely reference it, is a multi-currency portfolio with various weightings toward a base currency. Central banks use it to reference their currency against a diversified currency basket to lower exchange rate fluctuations, known as currency pegging. Market participants with cross-asset, cross-currency portfolios use it to hedge their exposure.
A currency basket may also benefit cross-border contracts to minimize Forex risks. For example, the European Currency Unit (ECU), now replaced by the Euro, or the Asian Monetary Unit (AMU), which consists of the Brunei Dollar, the Cambodian Riel, the Indonesian Rupiah, the Lao Kip, the Malaysian Ringgit, the Burmese Kyat, the Philippine Peso, the Singapore Dollar, the Thai Baht, the Vietnamese Dong, the Chinese Yuan, the
Japanese Yen, and the South Korean Won.
The US Dollar Index (USDX) remains the most traded currency basket and consists of the Euro (57.6%), the Japanese Yen (13.6%), the British Pound (11.9%), the Canadian Dollar (9.1%), the Swedish Krona (4.2%), and the Swiss Franc (3.6%).
A Currency Basket, How Does it Work?
The manager of a currency basket will choose currencies and weighting according to the objective of the currency basket. For example, a currency basket pegging leading Latin American economies to the Euro would include the Brazilian Real, the Mexican Peso, the Argentine Peso, the Colombian Peso, the Chilean Peso, and the Euro.
The weighting could equal the GDP percentage of the top five Latin American economies, comprising a total of its trade with the European Union and the rest in Euros. The EU remains the primary trading and investing partner of the Mercosur trade bloc and trails only China in total goods and services. Any combination is possible and up to the portfolio manager.
Given the volatility of individual currencies, all trade agreements between the EU and Mercosur could use a currency basket, smoothing volatility and enhancing the price stability of goods and services for each side.
A Currency Basket Example
Traders can create currency baskets if their Forex brokers offer access to a broad choice of currency pairs.
Here is a currency basket example most traders can recreate:
- Assume a trader believes the US Dollar will fall in value over the next twelve to eighteen months and computes the most significant move against the Euro, followed by the Swiss Franc, the British Pound, the Japanese Yen, the Canadian Dollar, the Australian Dollar, and the New Zealand Dollar
The currency basket could look like this:
- Buy the EUR/USD (25.0% weighting)
- Sell the USD/CHF (20.0% weighting)
- Buy the GBP/USD (15.0% weighting)
- Sell the USD/JPY (15.0% weighting)
- Sell the USD/CAD (12.5% weighting)
- Buy the AUD/USD (7.5% weighting)
- Buy the NZD/USD (5.0% weighting)
The trader could create a currency basket index, for example, setting the value at 100 on the day of the creation of this currency basket, then adjust it based on percentage moves of the portfolio.
Should the US Dollar depreciate, the currency basket will gain in value. While all seven currency pairs will contribute to growth, the US Dollar will move differently against the seven currencies. Therefore, each currency pair has a unique weighting, which the trader can swiftly adjust to reflect market conditions. Buying the US Dollar against the above currency basket example will hedge it against the downside while limiting the upside potential.
Currency Basket Usage
Current basket usage falls within two primary and one secondary objective. Since only the US Dollar Index (USDX) remains publicly listed, most currency baskets are internal creations by financial firms, companies, and sometimes individual traders.
The two primary currency basket usages are:
- Reducing currency risk, generally for portfolios with cross-currency assets
- Valuing a currency, usually a less traded one from an emerging or frontier market with a concentrated but well-integrated economy
The secondary currency basket usage is:
- A currency basket satisfies complex trading and hedging requirements, especially in derivative markets
Currency Basket Choice and Currency Basket Valuation Explained
The currency basket choice and valuation remain at the discretion of the central bank, issuing authority, or asset manager and should fulfill the primary objective of the currency basket.
Currency basket choice and objective examples:
- Currency baskets based on terms of trade
- Currency baskets based on exchange rates
- Currency baskets based on macroeconomic parameters, for example, trade balance
Currency selection depends on the importance of various currencies to fulfill the objective, and the weighting presents another significant variable.
Currency basket weighting methods:
- Economic models
- Bilateral or multilateral trade shares
- Existing currency baskets like the IMF SDR
Currency valuation methods:
- A geometric average to maintain predetermined currency weightings
- A harmonic average for price stability due to built-in appreciation bias
- An arithmetic average to maintain exchange rates with a nominal depreciation bias
Developing countries with intervention risks could mitigate it by pegging their home currency to a standard basket with fixed units of currencies, granting the home currency an identical value to the harmonic average model.
What is the SDR Basket and Its Relationship to a Currency Basket?
The IMF SDR basket, created in 1969, is an international reserve asset that supplements the official currency reserves of IMF member countries. Botswana, Libya, and Syria peg their currency to the IMF SDR.
A currency basket consisting of the US Dollar, the Euro, the Chinese Yuan, the Japanese Pound, and the British Pound determine the value of the SDR. IMF members can exchange their currencies for SDR, but SDR is not a currency. The IMF reviews the SDR every five years, and currency amounts remain fixed for the period.
Currency Basket Conclusion
A currency basket can help value lesser traded currencies from emerging and frontier markets, create exchange rate stability, and hedge against Forex risk in multi-currency portfolios.
FAQs
How many currencies does the IMF basket have?
The IMF currency basket consists of the US Dollar, the Euro, the Chinese Yuan, the Japanese Pound, and the British Pound.
How do I invest in a basket of currencies?
The US Dollar Index (USDX) remains a publicly listed currency basket most traders can access. Otherwise, asset managers and traders can create currency baskets in their portfolios. ETFs and ETNs can help construct diversified currency baskets while lowering the risk profile, especially if traders have no direct access to desired currencies.
What is the IMF SDR basket?
The IMF SDR basket is an international reserve asset created in 1969. Its primary function is to supplement the official currency reserves of IMF member countries. Since its creation, the IMF SDR basket has distributed a total of SDR 660.7 billion, approximately $943 billion. The bulk consists of the COVID-19 response, where the IMF approved an SDR 456 billion allocation. The value of 1.00 SDR remains based on the US Dollar, the Euro, the Chinese Yuan, the Japanese Pound, and the British Pound.