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A currency basket is a portfolio of selected currencies with different weightings. A currency basket is commonly used by investors to minimize the risk of currency fluctuations and also governments when setting the market value of a country's currency. An example of a currency basket is the European Currency Unit that was used by the European Community member states as the
unit of account In economics, unit of account is one of the functions of money. A unit of account is a standard numerical monetary unit of measurement of the market value of goods, services, and other transactions. Also known as a "measure" or "standard" of ...
before being replaced by the euro. Another example is the special drawing rights of the
International Monetary Fund The International Monetary Fund (IMF) is a major financial agency of the United Nations, and an international financial institution funded by 191 member countries, with headquarters in Washington, D.C. It is regarded as the global lender of las ...
. A well-known measure is the U.S. dollar index, which is used by
Forex The foreign exchange market (forex, FX, or currency market) is a global decentralization, decentralized or Over-the-counter (finance), over-the-counter (OTC) Market (economics), market for the trading of currency, currencies. This market det ...
traders. There are six currencies forming the index: five major currencies –
Euro The euro (currency symbol, symbol: euro sign, €; ISO 4217, currency code: EUR) is the official currency of 20 of the Member state of the European Union, member states of the European Union. This group of states is officially known as the ...
,
Japanese yen The is the official currency of Japan. It is the third-most traded currency in the foreign exchange market, after the United States dollar and the euro. It is also widely used as a third reserve currency after the US dollar and the euro. Th ...
, British pound,
Canadian dollar The Canadian dollar (currency symbol, symbol: $; ISO 4217, code: CAD; ) is the currency of Canada. It is abbreviated with the dollar sign $. There is no standard disambiguating form, but the abbreviations Can$, CA$ and C$ are frequently used f ...
, and
Swiss franc The Swiss franc, or simply the franc, is the currency and legal tender of Switzerland and Liechtenstein. It is also legal tender in the Italian exclave of Campione d'Italia which is surrounded by Swiss territory. The Swiss National Bank (SNB) iss ...
– and the
Swedish krona The krona (; plural: ''kronor''; sign: kr; code: SEK) is the currency of Sweden. Both the ISO code "SEK" and currency sign "kr" are in common use for the krona; the former precedes or follows the value, the latter usually follows it but, espec ...
.


History and current use

After major world currencies began to float in 1973, small countries in reaction decided to peg their currencies to one of the major currencies (e.g. U.S. Dollar, Pound Sterling). This led to a greater fluctuation against other major currencies and soon, some of the countries elected to manage the currency movements using more currencies, important for the given country, i.e. started to use currency baskets.International Monetary Fund. External Relations Dept., . (1986). "Pegging to a currency basket: The why and how of pegging under floating exchange rates". In '' Finance & Development, September 1986''. USA: INTERNATIONAL MONETARY FUND. Retrieved April 12, 2021. In following years, greater diversification in
international trade International trade is the exchange of capital, goods, and services across international borders or territories because there is a need or want of goods or services. (See: World economy.) In most countries, such trade represents a significan ...
led to greater use of the currency baskets and by 1985, according to IMF data, 63 countries had tried the currency basket policy and 43 of them were using it at the time. In the following decades, the number of countries that anchored their
exchange rate In finance, an exchange rate is the rate at which one currency will be exchanged for another currency. Currencies are most commonly national currencies, but may be sub-national as in the case of Hong Kong or supra-national as in the case of ...
to a currency composite declined and in 2019, there were only eight of them. Three tracked the special drawing rights (SDR) as the sole currency basket or as a component of a broader reference basket (
Botswana Botswana, officially the Republic of Botswana, is a landlocked country in Southern Africa. Botswana is topographically flat, with approximately 70 percent of its territory part of the Kalahari Desert. It is bordered by South Africa to the sou ...
,
Libya Libya, officially the State of Libya, is a country in the Maghreb region of North Africa. It borders the Mediterranean Sea to the north, Egypt to Egypt–Libya border, the east, Sudan to Libya–Sudan border, the southeast, Chad to Chad–L ...
,
Syria Syria, officially the Syrian Arab Republic, is a country in West Asia located in the Eastern Mediterranean and the Levant. It borders the Mediterranean Sea to the west, Turkey to Syria–Turkey border, the north, Iraq to Iraq–Syria border, t ...
).
Morocco Morocco, officially the Kingdom of Morocco, is a country in the Maghreb region of North Africa. It has coastlines on the Mediterranean Sea to the north and the Atlantic Ocean to the west, and has land borders with Algeria to Algeria–Morocc ...
tracked the euro and the U.S. dollar basket, and the remaining four countries did not disclose the composition of their reference currency baskets (
Fiji Fiji, officially the Republic of Fiji, is an island country in Melanesia, part of Oceania in the South Pacific Ocean. It lies about north-northeast of New Zealand. Fiji consists of an archipelago of more than 330 islands—of which about ...
,
Kuwait Kuwait, officially the State of Kuwait, is a country in West Asia and the geopolitical region known as the Middle East. It is situated in the northern edge of the Arabian Peninsula at the head of the Persian Gulf, bordering Iraq to Iraq–Kuwait ...
,
Singapore Singapore, officially the Republic of Singapore, is an island country and city-state in Southeast Asia. The country's territory comprises one main island, 63 satellite islands and islets, and one outlying islet. It is about one degree ...
,
Vietnam Vietnam, officially the Socialist Republic of Vietnam (SRV), is a country at the eastern edge of mainland Southeast Asia, with an area of about and a population of over 100 million, making it the world's List of countries and depende ...
).


Use and benefits

Baskets of currencies are ideal for small countries with less diversified production, which are well integrated with the global economy and thus more vulnerable to external disturbances. These countries tend to have smaller volumes of foreign exchange transactions, relatively inelastic trade flows, and less developed
financial market A financial market is a market in which people trade financial securities and derivatives at low transaction costs. Some of the securities include stocks and bonds, raw materials and precious metals, which are known in the financial marke ...
s, which can make free floating exchange rates costly. At the same time, peg to a single major currency would lead to an undesired float against other currencies corresponding to the float of the currency to which the country’s currency would be pegged. The use of currency baskets generally leads to a more stable international trade competition, mitigates shocks to a country's trade balance and stabilizes its GDP. Basket pegs might also reduce an inflow of foreign short-term capital which is likely to be subject to a short-term exchange rate risk and to a sudden reversal in the direction of the capital flow. In other words, the basket-peg regime makes the country less dependent on risky foreign capital, while not affecting long-term foreign investments such as portfolio and direct investments.Ogawa, Eiji & Ito, Takatoshi & Sasaki, Yuri. (2021)
Costs, Benefits, and Constraints of the Basket Currency Regime.
Retrieved April 12, 2021.


Basket choice

The choice of a basket should be based on a policy objective of the authorities. This objective can be defined as a relative price variable like the terms of trade and the real exchange rate, or as a
macroeconomic Macroeconomics is a branch of economics that deals with the performance, structure, behavior, and decision-making of an economy as a whole. This includes regional, national, and global economies. Macroeconomists study topics such as output/ GDP ...
variable such as the balance of trade and the balance of payments. Once the objective is defined, the choice of currencies and their weights in the basket can be made on the basis of the relative importance the authorities attach to an exchange rate stability against various currencies. The greater the vis-à-vis stability required, the greater the relative weight of a currency in the basket should be and selecting a basket with only a small number of currencies is generally preferred as the subsequent basket operation becomes easier. Three approaches towards determining the ideal relative weights are used. Some countries rely on their own econometric models, which are based on the country’s payments and trade with their partners and indirect effects of other countries in the same markets. Others set the relative weights based purely on bilateral trade shares, which, however, might not be the optimal solution, and some elect to use ready-made baskets (e.g. SDR) – especially if its shares contain the country's trade partners. The authorities should regularly review the relative currency weights in the basket and adjust them based on current economic situation.


Basket valuation

Choice of currency weights does not itself determine the value of home currency as the same set of weights can result in different values depending on a method used to weigh changes in the component currencies. Choice of the averaging method is made based on currency characteristics that are deemed desirable. A geometric average method should be used when authorities’ policy objective is maintaining predetermined currency weights. A harmonic average method has a built-in appreciation (anti-inflation) bias and thus is optimal for price stability. An arithmetic average is best for maintaining the real effective exchange rate with its bias towards nominal
depreciation In accountancy, depreciation refers to two aspects of the same concept: first, an actual reduction in the fair value of an asset, such as the decrease in value of factory equipment each year as it is used and wears, and second, the allocation i ...
. More information about averaging methods with a specific exampl
here
One issue of the basket peg is that because the home currency fluctuates against the currency used for interventions in the economy, the provision of forward facilities may become a problem for many
developing countries A developing country is a sovereign state with a less-developed Secondary sector of the economy, industrial base and a lower Human Development Index (HDI) relative to developed countries. However, this definition is not universally agreed upon. ...
. In such cases, the policymakers should peg the home currency to a standard basket, which is a basket consisting of fixed physical units of currencies. Given the same set of currencies, the standard basket method should give the same value of the home currency as the harmonic average method. In practice, some minor currencies that are not traded in the market may have to be excluded from the standard basket and the weights of remaining currencies that are positively correlated with the excluded currencies should be increased.


Operation of a basket peg

Several issues, which do not occur in the operation of a single currency peg, arise with the currency basket peg. They include how often to quote the exchange rate, whether or not to disclose the basket composition and how wide of a currency band margin to maintain. These issues arise from the fact that the exchange rate of the home currency constantly changes in terms of the currency that is used to intervene in the market to maintain the value of the basket, but the rate is still dictated by a specific exchange rate rule. In theory, to adhere strictly to a basket peg rule under given conditions, the authorities must continuously calculate and quote the exchange rate against the intervention currency and must always be ready to sell or buy whatever amount of the intervention currency is necessary to support that rate. This is impossible to achieve in reality, thus a strict basket peg policy is not practicable. Less frequent exchange rate quotations (e.g. once a day) require at least a minimal margin around parity as the official exchange rate, quoted in intervals, may differ from the constantly changing theoretical rate. This deviation makes the basket-pegged currencies more vulnerable to
speculation In finance, speculation is the purchase of an asset (a commodity, good (economics), goods, or real estate) with the hope that it will become more valuable in a brief amount of time. It can also refer to short sales in which the speculator hope ...
as foreign exchange dealers may short-sell or short-buy them more often. To prevent the speculations, most countries with tailor-made baskets have decided not to publicly disclose the composition of their baskets. To ensure currency’s security, authorities may further vary the margins around the parity value unpredictably to dissuade foreign dealers from estimating the basket composition based on the currency’s exchange rate movements against other currencies. They may also adjust basket’s value or composition to offset a loss of competitiveness or to accommodate a change in a structure of the country’s trade. Excessive use of the interventions may, however, lead to a loss of monetary discipline and credibility which are key for proper functioning of the basket peg valuation system.


Currency basket in investing

The currency basket is generally used to avoid high currency volatility. This can be used in Forex trading, which is based on the opposition of one currency against another. Thus, a big jump of either currency can create unpleasant circumstances for the trader. If a Forex investor chooses to trade the United States dollar against many other currencies, they should use the U.S. dollar index. Traders can compose their own baskets with different weights and apply them to any trading strategy.


See also

*
Currency A currency is a standardization of money in any form, in use or circulation as a medium of exchange, for example banknotes and coins. A more general definition is that a currency is a ''system of money'' in common use within a specific envi ...
*
Exchange rate regime An exchange rate regime is a way a monetary authority of a country or currency union manages the currency about other currencies and the foreign exchange market. It is closely related to monetary policy and the two are generally dependent on many ...
* Fixed exchange rate system *
Floating exchange rate In macroeconomics and economic policy, a floating exchange rate (also known as a fluctuating or flexible exchange rate) is a type of exchange rate regime in which a currency's value is allowed to fluctuate in response to foreign exchange market ...
* Managed float regime *
Foreign exchange market The foreign exchange market (forex, FX, or currency market) is a global decentralized or over-the-counter (OTC) market for the trading of currencies. This market determines foreign exchange rates for every currency. By trading volume, ...
* Basket (finance) * WOCU


References

{{Authority control Currency Foreign exchange market Securities (finance)