Does The US Dollar Index Reflect Current Reality?

Published by Filipe R. Costa on Thu, 28/07/2011 - 17:30
research paper

The Current Reality for the USD Index

The US Federal Reserve created the US Dollar Index in 1973 to track the country's currency against a basket of other currencies. The Index is the result of a geometrically weighted average of six currencies against the US Dollar: the Euro, the Japanese Yen, the Great Britain Pound, The Canadian Dollar, the Swedish Krona, and the Swiss Franc.

Before the Euro was created the index was composed of ten components, but the adoption of a single currency in Europe extinguished five of those currencies urging for a change in the index components. Besides that adjustment, the US Dollar Index was never adjusted or rebalanced and there is no scheduled adjustment. The index is not updated to reflect the real trade volume for each component pair. As a result, the AUD/USD is not part of the calculation even though it is the fourth most traded USD pair. The weights given to each currency also do not correspond to the current turnover reality. The Swedish Krona, for example, is currently less traded than the Hong Kong Dollar and the South Korea Won but it is part of the US Dollar Index while those currencies are not.

Cut The Spread decided to investigate what would happen if the index were adjusted and rebalanced to reflect updated Forex turnover. Would the results be much different? Is the US Dollar Index reflecting reality?

A Short Investigation

In order to achieve our goal, we collected foreign exchange data from surveys conducted by the Bank of International Settlements (BIS), which publishes data every three years.

The turnover data published by BIS refers to daily numbers collected during the month of April. From the stated data we have chosen the six most traded USD pairs and calculated their share in total turnover. The table below shows our findings:

US Dollar Daily Turnover (in billion USD)
  April 2010 April 2007
  Weight Turnover Weight Turnover
EUR/USD 41.89% 1101 40.99% 892
USD/JPY 21.61% 568 20.13% 438
GBP/USD 13.70% 360 17.65% 384
AUD/USD 9.47% 249 8.50% 185
USD/CAD 6.93% 182 5.79% 126
USD/CHF 6.39% 168 6.94% 151

In order to compare our calculated proportions to the real ones, let’s look into the US Dollar Index components:

US Dollar Index Components Table
EUR/USD 57.60%
USD/JPY 13.60%
GBP/USD 11.90%
USD/CAD 9.10%
USD/SEK 4.20%
USD/CHF 3.60%

The first difference to note is the lack of Swedish Krona in the six most traded USD pairs according to BIS data. Instead, we have the AUD/USD as the fourth most important. A second great difference is in the relative importance the pair EUR/USD should have. BIS data gives this pair much less relevance than it is attributed to it in the US Dollar Index. Besides those differences, the Japanese Yen is also understated, as is the Swiss Franc. The Pound has lost some importance between 2007 and 2010 and is currently almost in line with its index weight. The Canadian Dollar grew in importance but is overstated in the index. Resuming: we should substitute the Swedish Krona by the Australian Dollar; give less importance to the Euro and the Canadian Dollar, and give more weighted to the safe-heavens Japanese yen and Swiss Franc.

Creating a new US Dollar Index

Now that we retrieved real proportions for the six most traded USD pairs, we can compute a new US Dollar Index. We start our new index at the end of April 2007 with the turnover reported on BIS report and then rebalance the index in the end of April 2010 to reflect the new data reported at that time.

The USD Index is calculated in the following way:

USD Index = 50.14348112 X EUR/USD^-0.5760 X USD/JPY^0.1360 X GBP/USD^-0.1190 X USD/CAD^0.0910 X USD/SEK^0.0420 X USD/CHF^0.0360.

There are a few constants in the formula. The first one is 50.14348112. The reason for its existence is that the FED started coverage of the index attributing it a value of 100. Since all other values could not be changed, this constant is what makes the adjustment. We will call this constant K. The other constants are exponents. They represent weights for each pair and if we sum all we obtain a value of one, or 100%.

At the last trading day of April, the Index was priced at 81.47. In order to rebalance it, we basically need to use closing prices for our six USD pairs for the end of April 2007, their weights based on April 2007 turnover and then equate everything to be equal to 81.47. We need to recalculate K, in order to get a price of 81.47.

Real Prices For USD Pairs and the USD Index
  27-April-2007 30-April-2010 14-July-2011
EUR/USD 1.3650 1.3294 1.4159
USD/JPY 119.50 93.84 79.02
GBP/USD 1.9990 1.5265 1.6252
USD/CAD 1.1150 1.0177 0.9593
USD/SEK 6.6910 7.2418 6.4944
USD/CHF 1.206 1.0775 0.8139
AUD/USD 0.8298 0.9241 1.0733
USD Index 81.47 81.91 75.13

At the end of April 2010 we need to apply the same procedure, but apply the weights for that period. The above table summarises our results. 

US Dollar Index Summary of Results
    27-April-2007 30-April-2010 14-July-2011
US Dollar Index Price 81.47 81.91 75.13
  K 50.14 50.14 50.14
  Performance ----- 0.54% -8.28%
Rebalanced Index Price 81.47 80.46 72.26
  K 38.55 35.51 -----
  Performance ----- -1.24% -10.19%

 

Between April 2007 and April 2010, the US Dollar Index rose 0.54%, but our rebalanced index dropped by 1.24%. In the subsequent period between the end of April 2010 and 14 July 2011 both dropped but the decrease was more severe for the rebalanced index. Considering the whole period, the US Dollar Index dropped 7.78% and the rebalanced index decreased by 11.30%. There is a huge difference between the two.

During the period considered we have been through a recession. Times have been of financial trouble and the FED engaged in monetary easing driving it key interest rate to near zero. The USD suffered from monetary easing and currencies like the JPY and the CHF have earned some of the safe-heaven status attributed to the USD. Those currencies registered huge gains against the US Dollar during the period.  Since they are understated in the US Dollar Index, the real effect in our rebalanced index is much larger. At the same time, commodities, especially gold, have been rising pushing the AUD higher, a currency that is not part of the USD Index calculation, also contributing for the difference between the real index and our rebalanced calculation.

Conclusion

Our study shows that in the period between the end of April 2007 and mid-July 2011 the US Dollar Index understated the drop of the US currency by 45% due to a lack of rebalance and adjustment of its components to reflect real currency exchange data. Although the index may work as a surrogate for the USD value, it is not the best match for it. The Swedish Krona lost importance in Forex and the Australian Dollar is now one of the most important currencies, in terms of USD pairs and that reality is incorrectly reflected in the USD index. At the same time both JPY and CHF are understated in the index, contributing to a deviation from reality.

The US Dollar Index and Spread Betting

Several spread betting companies offer trading in the US Dollar Index. You can trade that market instead of going for USD pairs. Since spread betting is for short-term trading, the USD Index rebalance issue will not affect you by much and the index continues to be a good surrogate for the US currency value. In the long term, as we have seen above, the US Dollar Index may deviate from reality and do not work well as a tracker for USD.

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Research & Opinion