New Dollar Index, Same Old Problems
Different approaches to weights and compositions naturally produce different results.
This parable is replete with meaning for indexation of all stripes. When the solution to a problem is unknown, answers proliferate. This is why we have equal-, price-, fundamental-, and capitalization-weighted indices for equities and numerous approaches to commodities, such as the S&P-Goldman Sachs and Dow Jones-UBS indices.
Currencies present an even worse problem. Consenting trading partners transact in a given currency; you buy Chinese goods to put on the shelves at Wal-Mart (NYSE:WMT) -- or for whoever has your Target (NYSE:TGT) credit card at the moment -- and you must sell dollars to buy yuan. You do not sell a dollar index; nor does an importer of American goods sell, say, euros to buy a dollar index. On the financial side of the transaction, you can borrow euro deposits and lend dollar deposits without ever transacting in actual goods, but why would you trouble yourself to borrow a weighted basket of currency deposits to lend into the dollar?
The term "dollar index" generally defaults to the ICE dollar index (DXY) whose weights, as noted here recently in another context, have remained unchanged since 1973 even though the world has changed here and there. Bloomberg has constructed a 10-member family of currency indices whose weights are based on their correlations against one other (BCWI). It recently added a spot dollar index (BDXY) whose weights are based on trade flows and financial liquidity. These weights are recalculated annually and are presented below for the index' history since the end of 2004.
A total of 20 currencies are considered for inclusion, of which 10 make the cut every year. This is why smaller currencies such as the Singapore and Taiwan dollars (SGD and TWD) or Swedish krona (SEK) make cameo appearances. If you have good eyesight and a high-resolution screen, you may also notice the yuan's weight is a constant 3%. This managed weight is done in response to the managed CNY; touché!
These different weights and compositions naturally produce different results. While the BDXY advanced 2.08% between December 2004 and November 2013, the BCWI and DXY declined 4.00% and 0.21%, respectively. A map of the weighted variances for each currency using 2013 weights shows some very prominent differences between each currency's weighted returns in either the BCWI or DXY and the BDXY.
These different approaches will continue to produce different results. In addition, they will stimulate the creation of new and different indices. What should you do? To go back to my answer for commodity indexation, if you want to trade gold or crude oil, trade gold or crude oil; why add corn or cocoa into the mix? If you want to trade the euro or yen, trade the euro or yen. Real answers to real problems are simple when we allow them to be.
The information on this website solely reflects the analysis of or opinion about the performance of securities and financial markets by the writers whose articles appear on the site. The views expressed by the writers are not necessarily the views of Minyanville Media, Inc. or members of its management. Nothing contained on the website is intended to constitute a recommendation or advice addressed to an individual investor or category of investors to purchase, sell or hold any security, or to take any action with respect to the prospective movement of the securities markets or to solicit the purchase or sale of any security. Any investment decisions must be made by the reader either individually or in consultation with his or her investment professional. Minyanville writers and staff may trade or hold positions in securities that are discussed in articles appearing on the website. Writers of articles are required to disclose whether they have a position in any stock or fund discussed in an article, but are not permitted to disclose the size or direction of the position. Nothing on this website is intended to solicit business of any kind for a writer's business or fund. Minyanville management and staff as well as contributing writers will not respond to emails or other communications requesting investment advice.
Copyright 2011 Minyanville Media, Inc. All Rights Reserved.
Daily Recap Newsletter