Trade-Weighted Exchange Rate
Form of measuring a particular country's exchange rates.
What is Trade-Weighted Exchange Rate?
A trade-weighted exchange rate is a form of measuring a particular country's exchange rates. It is a more complex measure of doing so and involves measuring the currency's strength according to the weightage of trade it has with other countries.
It is influenced by the degree and volume of trade between two countries. So, for example, if the degree of trade between two countries is low, the change in exchange rates of one would have a low impact on the trade-weighted exchange rate of another due to the low share of trade.
Similarly, with a higher degree of trade which implies a significant share of the trade of a country, a change in the rates of such a nation would cause a more significant change in the trade-weighted exchange rates.
Such an exchange rate implies that if such an index rises and all other things are equal, the purchasing power of the people would also rise.
This would also impact its imports and exports as due to the increased value of the currency, the cost of imports would go down, but so would the competitiveness of exports.
Key Takeaways
- Trade-rated exchange rates are a more complex method of calculating the value of a currency by taking into account weightage and degree of trade with the most frequent international trading partners.
- It helps in establishing the actual value and purchasing power of the country. An increase in the exchange rate implies an increase in purchasing power leading to cheaper imports and less competitive exports.
- It works by assigning a higher weightage to countries with which the degree of trade has been more. This will mean a change in the currencies of these countries will result in a more significant change in the trade-weighted exchange rates.
- The process of calculating such an exchange rate involves calculating the geometric mean of the top trading partners according to the weights assigned. The change in the Index from the base year indicates the overall change in the currency.
- An example of such an index is the US Dollar Index, which considers the Euro, Yen, Krona, Pound, Franc, and Canadian Dollar.
- However, such exchange rates are not always completely reflective of the currency's actual value as they fail to consider other forms of movement of capital, customs officers miss trades, and the demand for international reserves.
Understanding trade-weighted exchange rates
This mode of a weighted exchange rate is used to determine the purchasing power of a domestic currency and find the effects of the appreciation and depreciation of domestic currencies against other foreign currencies.
The index works by assigning weights to the countries where the maximum share of weights occurs.
This is because comparing the domestic currency to all international currencies would be less fruitful as a change in the currency of a nation with which the country's trade is very limited or negligible would not have as significant an impact on the value of the currency as compared to changes in the currency of a major trading partner.
For example, if the USA were trading primarily with the UK and comparatively lesser with China, it would assign a higher weight to the UK and a lower weight to china.
Thus a change in the value of the British pound would affect the index more than a change in the currency of China.
The index helps determine the purchasing power of the people of the domestic country and the currency's actual value.
Thus if the British pound were to go down in the above scenario, the relative value of the US Dollar would increase, which would lead to more imports, as they would become comparatively cheaper. In contrast, the exports would become more expensive.
Calculation of Trade-Weighted Exchange Rate
Firstly the country will have to identify the top 5 countries with maximum trading relations. Different weights would then be given to the countries depending on the level of trade with the domestic country.
This means that the higher the level of trade, the more weightage it will have in the overall index, and vice versa. Conversely, the lower the level of trade, the lower the weightage it will have.
The index would then be calculated using a geometric mean. The formula for the same is as follows:
TWIt = 100 * Π [eit/eio]wit * IND
In the above scenario, the symbols represent the following:
- TWIt: This represents the final Trade weighted index
- Π: This represents the product of the bracketed value over the five currencies with the maximum weightage
- Eit: This represents the foreign currency units per unit of domestic currency during time t
- Eio: This represents the foreign currency units per unit of domestic currency during the base period
- Wit: This represents the weight of the trading partner at time t
- IND: This represents the scale factor which ensures that the index does not change with the quarterly re-weighting solely as a change in currency weights
Thus the mean of all the top currencies with respect to the weightage, the currency traded in the current and base year, will be taken out. All five would then be added and multiplied with 100 and the scale factor (IND) to achieve the final value of the trade-weighted index.
Trade-Weighted Exchange Rate Example
An example of such an index can be the US Dollar Index. It is the leading benchmark for the international value of the USD and the world's most widely traded and well-known traded currency index.
The federal reserve established it in 1973 after the Bretton Woods agreement was dissolved.
The index uses a basket of six currencies: The Euro, the Swiss Franc, The Japanese Yen, The Canadian Dollar, The British Bound, and The Swedish Krona to measure the value of the US Dollar.
The Euro has been given the maximum weightage in the index, being almost 57.6% of the basket, followed by the Yen being 13.6%, the pound being 11.9%, the Canadian Dollar being 9.1%, the Krona being 4.2%, and lastly, the Franc being 3.6%.
The weights were allotted according to the level of trade with the US. Therefore, the index has mostly been accepted as a fair indication of the actual value of the US Dollar.
The base value of the index was taken as 100, and the current value can tell by how much the US Dollar has improved since the base period.
For example, if the index were at 120, it would mean a growth of 20% since the base period, while if the index were at 90%, it would mean a fall of 10% since the base period.
In August 2022, it was at 108, showing that since the base period, the Dollar grew by 8%.
Problems with the Trade Weighted Index
While a few years ago, when trade was the only primary reason for the flow of currencies from one country to another, trade-weighted exchange rates could be more effective; however, now, due to the advent of globalization, they are becoming less and less effective.
This is because now there are many more reasons for the flow of currencies from one country to another.
This may be due to loans, grants, investments, etc. Moreover, as they increase in volume and frequency, taking into account trades to find the actual value of currencies may be insufficient.
These other factors should also be considered to accurately judge the currency’s true value.
Additionally, the degree of trade is often judged inaccurately. For example, the trade may often be undervalued if it has not been recorded by the customs, thus leading to a misleading figure which may not show the actual value of the exchange rate.
Lastly, the currency is not just used for international trade, but it also can be in demand due to it being an asset for international reserves. Thus the exchange rate may not give an accurate and fair reflection of the purchasing power of the people.
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