Grasp currency basket overview and construction methods

2023-08-14
Summary:

A basket of currencies is a monetary unit that uses a combination of multiple foreign currencies as a reference for exchange rates, and the proportion of a certain foreign currency in the combination is based on its importance in domestic international trade.

Overview of a basket of currencies

A basket of currencies refers to a combination of foreign currencies used as a reference for setting exchange rates, and the proportion of a foreign currency in the combination is usually based on the importance of that foreign currency in the country's international trade. For example, if 40% of a country's imports and exports are denominated in US dollars, the weight of the US dollar in the country's basket of currencies may be 40%.


The People's Bank of China announced that, with the approval of the State Council, starting on July 21, 2005, China will implement a managed floating exchange rate system based on market supply and demand, with reference to a basket of currencies for adjustment.


The RMB has changed its exchange rate system from being tightly pegged to the US dollar to referring to a basket of currencies.


The so-called reference to a basket of currencies refers to a country selecting several major currencies based on their close trade and investment relationship, setting different weights for different currencies to form a basket of currencies, and setting a floating range. The country's currency will float within the range based on this basket of currencies.


There are approximately five current exchange rate systems internationally, including the "dollarization" system, where other countries' currencies are used as their legal compensation currency; A "linked exchange rate system" that maintains a fixed exchange rate relationship between domestic currency and a major international currency Pegging the domestic currency exchange rate to a specific currency or basket of currencies, regularly reviewing changes in domestic and foreign economic and financial situations, and resetting the "adjustable pegged exchange rate system" with fixed exchange rate targets; A "managed floating exchange rate system" in which the central bank can intervene appropriately; And "fully floating exchange rate systems" such as the Japanese yen, US dollar, and Eurozone currencies.


Method of constructing a basket of currencies

A basket of currencies is a composite currency formed by combining an existing set of currencies in a certain way. A basket of currencies is not a real currency but a unit of account and pricing standard. It is used by some countries for exchange rate management, such as pegging their own currency to an existing or constructed basket of currencies or referencing a basket of currencies in Et constant exchange rate management.


From a technical perspective, constructing a basket of currencies involves four steps:

1. Select the currency composition of the currency basket. To avoid practical operational issues caused by the complexity of exchange rate and interest rate calculations, the currency basket should be selected based on the close degree of economic and trade relations with the country.


2. Determine the weight of various currencies. The weight reflects the importance of the impact on the domestic currency exchange rate. In order to stabilize the effective exchange rate, most countries choose bilateral trade as the basis for calculating weights. On this basis, weights can also be adjusted based on factors such as the country's position in the world economy, bilateral capital flows, and direct investment.


3. Determine the base period exchange rate levels of the most important basket currencies, such as the US dollar, domestic currency, and other basket currencies. The determination of the base period exchange rate is very important. If the base period exchange rate is not an equilibrium exchange rate, there will be a systematic deviation in the calculated basket exchange rate.


4. Calculate the quantity of various currencies in the currency basket based on the determined weights and base period exchange rates. For example, if the base exchange rate between the domestic currency and the main basket currency i is 8, that is, 1 unit of i currency is equal to 8 units of domestic currency, and the weight of i currency in the currency basket is 40%, then the number of i currencies contained in the currency basket is 0.05 (40%) × 1/8=0.05). The weight of j currency in the currency basket is 10%, and the exchange rate is li=10Oj, then the quantity of j currency contained in the currency basket is 1.25 (10% × 1/8 × 100). By analogy, the quantity of basket currencies can be calculated.


Once the currency basket is determined, the basket exchange rate can be calculated based on the market exchange rate. For example, to calculate the exchange rate BER of a basket of currencies against currency i, convert the various currencies in the basket into currency i at market exchange rates and add them up. order ρ J is the quantity of currency j contained in the basket, ei, j is the exchange rate of currency i in the market against i, then BERi; the calculation formula is:
BERi= Σ ( ρ J * ei, j)
If the domestic currency is strictly pegged to that basket of currencies, then BERi is the exchange rate of the domestic currency against currency i.


Most domestic literature and scholars have the misconception that the weights of various currencies included in a basket of currencies remain unchanged. The fact is not that; the number of basket currencies is fixed and will only change when the weight is adjusted once. The determination of weight is only one step in constructing a basket of currencies, with the purpose of determining the quantity of the basket of currencies. In operation, the weight changes with changes in market exchange rates.


Disclaimer: Investment involves risk. The content of this article is not an investment advice and does not constitute any offer or solicitation to offer or recommendation of any investment product.

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