After the abolition of the gold standard, many countries began to look for ways to minimize currency risks. But, as practice has shown, the currency basket turned out to be the most reliable tool for ensuring the security of the national currency and controlling the dynamics of its exchange rate. Moreover, traders are constantly in search of the highest currency value in world in order to invest their money and receive income.
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A currency basket is an effective tool for assessing the value of a currency
Before talking about the currency basket, you need to define what is meant by this term. In economic theory, it is generally accepted that a currency basket is an arbitrarily formed set of several foreign currencies, the weighted average of which is used to determine the value of government debt or the value of the national currency.
Let’s assume that a country that has issued its own currency wants to objectively assess its value. Moreover, most contracts and international obligations are invested in euros, American dollars, and British pounds. Therefore, the state can set the price of a currency as the cost of a basket, which includes (in a certain proportion) euros, dollars, and pounds. This will make it possible to obtain an objective estimated value of the national currency in all international payments.
In practice, a basket of currencies allows you to regulate the balance of payments of member countries of the International Monetary Fund replenish reserves, and pay off loans provided by the Monetary Fund.
Currency basket and currency index
Traders working in financial markets often confuse the concept of a currency basket and a currency index. This is due to the fact that working with a basket of currencies is similar in content to portfolio investments (a trading operation with several assets to reduce the risk component associated with exchange rate fluctuations).
A basket can consist of a set of different currency pairs. It is not necessary to have a specific base currency. If we are talking about indices, then they must demonstrate the general trend for a specific currency.
An example would be the dollar index. It shows the ratio of the value of the US currency to the value of a basket of major currencies. The code of such an index is purchased, which actually opens a long position in currency pairs where the dollar is the base currency and a short position in those pairs where the dollar is the quote currency. In this case, it is obvious that it is incorrect to talk about trading a basket.
Selling the dollar index would mean buying the basket of currencies included in the index. But this is only a special case, on the basis of which it is unacceptable to talk about the identity of the concepts of “currency basket” and “currency index”.
Currency basket in the Forex market
When used skillfully, the currency basket provides great opportunities for traders trading on the Forex currency market. Having such a basket allows you to:
- diversify risks when making trade transactions. Working with one currency does not allow you to do this. When creating a basket of currencies and working with it, this opportunity appears;
- determine the weight of a particular asset and its impact on the dynamics of currencies forming a pair with it;
- group currency pairs whose behavioral characteristics are important. Such signs include the relationship between the price of petroleum products and the exchange rate, the correlation between currency pairs;
- create an effective trading strategy that allows you to conduct transactions not with one asset but with several. This achieves not only the profitability of currency trading but also reduces the risk component.
From all that has been said, we can conclude that in conditions of instability of exchange rates of individual currencies, the presence of a currency basket is a necessity. At the state level, with its help, it is possible to achieve a significant reduction in currency risks and validity in international payments. Regular traders can also take advantage of the benefits provided by currency baskets.
By forming such a basket, they can significantly improve the quality of their trading in the financial markets.