The TWI represents how well a currency is doing against a basket of other currencies. The currencies included in the TWI reflect the major trading relationships with the index currency. Each currency receives a weight in the index that reflects its importance. For example, Japan is Australia’s major trading partner and as a result has the greatest weight in the Australian TWI. In looking at the Canadian currency, the United States is by far the greatest trading partner and the U.S. dollar would receive the greatest weight.
How can the TWI be accessed by the trader? The International Index Company issued a new product line called IboxxFX, which are indexes that are trade weighted. Anyone can register and access these important TWI charts (www.iboxx.com). They allow forex traders to take a snapshot of the strength of a currency.
If you want to know how strong the U.S. dollar is, you have to look at it against a particular currency. But looking at the U.S. dollar’s TWI gives us a global perspective rather than a currency pair perspective.
In the table in “Dividing the dollar” we see the TWI weights of the U.S. dollar produced by IboxxFX compared with the weights of the dollar index on the New York Board of Trade (Nybot). Nybot overweights the euro and also includes the irrelevant Swedish krona.
Let’s now compare the IboxxFX TWI U.S. dollar performance with the USDX on Nybot (see “Different measures,” below). The Iboxx TWI U.S. Index shows greater dollar strength than the USDX, reflecting more accurate trading patterns. In the USDX chart, the dollar hit new lows at the end of 2006. In contrast, the TWI Iboxx Index shows no such breakdown. Traders using the USDX would tend to be more bearish.
Which is the better index? If one believes currencies reflect fundamental forces, then the TWI Iboxx Index is more accurate. The fundamental lesson is that in making judgments about the strength or weakness of the dollar, relying on popular measures such as the USDX may expose the trader to misjudgments about the underlying reality of the dollar’s global position. Before you trade a particular pair, scanning the TWI charts of each currency that makes up the pair can increase your strategic accuracy.
Abe Cofnas is president of learn4x.com LLC and author of Understanding Forex: Trading to Win. E-mail: firstname.lastname@example.org.