Introduction:
Different countries in the world have varying currencies. For example, the currency of India is “Rupee”, the currency of the United States of America (USA) is “The US Dollar”, and the currency of Great Britain is “Pound”.
As an investor, you can trade in various foreign currencies and benefit from the fluctuations in their exchange rates. This type of trading is known as Forex Trading.
But do you know how different countries determine their currency exchange rates against various foreign currencies? A currency basket helps in this activity.
This article tries to shed light on what a currency basket is, how it works, the examples of a currency basket, and how you can benefit as an investor. Keep reading.
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What is a Currency Basket?
A currency basket is a portfolio (or basket) of various currencies with different weights as measured against a base currency. Each currency's weightage value helps determine its exchange rate concerning the base currency. A currency basket is also known as the “currency cocktail” among forex traders.
As an investor, you can use the currency basket to calculate the market value of different currencies and take trading positions accordingly. This practice is commonly known as the “currency peg”.
Some common examples of currency baskets include:
- The Asian Currency Unit, which is a proposed basket of prominent Asian countries
- The European Currency Unit, which is a proposed basket of European countries
- The US Dollar Index, which is a proposed basket of six prominent currencies in the world
The importance of a currency basket
Currency baskets carry significant importance for investors and a country’s monetary authority. A currency basket helps determine appropriate currency exchange rates for the monetary authority. Whereas, for investors, it helps in minimising the risks associated with currency exchange-rate fluctuations. Continue reading to know how:
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Determining currency exchange rates
A country’s monetary authority – such as the Reserve Bank of India (RBI) in India and the Federal Reserve (or the Fed) in the USA – uses the currency basket as a reference to determine the exchange rate for its currency against other prominent currencies in the world. Using a currency basket with multiple foreign currencies, instead of just pegging to a sole currency, helps them control the fluctuations in exchange rates.
For example, when you compare the US Dollar and the Canadian Dollar exchange rate, you will find that the value of the USD appreciated against the CAD over a specific period. It means the USD is the stronger currency among the two, and its value has risen against the CAD.
However, when you compare the USD with other currencies in the world, you will notice that the value of the USD has depreciated. But because the value of the CAD has depreciated even more, the USD looks like a stronger currency in a two-way comparison. But when you look at the currency basket, you can conclude that both currencies have become weaker as their values have declined concerning other currencies in the basket.
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Reducing exchange-rate fluctuation risks
Forex traders are exposed to the risks associated with currency exchange-rate fluctuations. Even equity traders who invest in foreign securities are exposed to such risks. It means that even if their investments in foreign securities have yielded good results, unfavourable currency exchange rates may wipe out the profits.
You can use a currency basket to minimise the impact of the currency exchange rate fluctuation risks. You can invest in multiple currencies to diversify the potential risks. This way, even If one of the currencies in your portfolio performs poorly, the others will fetch you the desired profit.
How to create a currency basket?
You can create your currency basket with different weightings as an investor or trader. Creating a currency basket involves two steps:
- Selecting different currencies as per your trading purpose. For example, if you are looking to mitigate currency-fluctuation risks, you can choose stable and liquid currencies
- Selecting the weightage of each currency. If you are looking for minimum risks, you can give high weightage to stable currencies and vice-versa
To conclude
As you know, currency baskets serve two purposes – determining the value of a currency and mitigating exchange-rate fluctuation risks. You can create your currency basket according to your investment strategy, risk appetite, and financial goals.
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