How strong is a currency? This question is fundamental to the forex trader. Because trading is the act of buying or selling one currency against another, traders usually think about the currency pair and not the currency itself.
When a trader makes a judgment about the strength of a currency by only using a currency pair context, that judgment can be misleading.
To enable an answer to the question of how strong a particular currency is on its own terms, the Trade Weighted Index (TWI) is used by economists and
should
also
be
used by currency traders.
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.
Each year the weights change to reflect changing realities of international trade. As
China
increases its trading relationships with other nations, it will receive more weight in
TWIs
.
TWI
represents a way of gauging the change in value of a currency in terms of the real global trading patterns of the country the currency represents. By knowing the
TWIs
of each currency, the forex trader can detect changes in the value of a currency and also how a currency can be affected by events in countries of their trading partners.
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
.