How the US Dollar Index shows the strength of the dollar
May 4th, 2008 | by mbhunter |A friend at work has mentioned the US Dollar Index a few times in conversation — mainly with reference to how low it is getting recently. Within the past two months it’s touched below 71, which is as low as it’s been since its inception in March 1973.
What does this number mean? How bad is 71? 71 what? Well, I went looking, and here’s what I found. An easy-to-understand introduction is here.
This particular index compares the US Dollar to a basket (set) of six other major currencies: the euro (EUR), the Japanese yen (JPY), the Pound sterling (GBP), the Canadian dollar (CAD), the Swedish krona (SEK), and the Swiss franc (CHF). The index itself is a weighted geometric mean of the current exchange rates of the USD with the other currencies:
···USDX = C Π (ERUSD,i)fraci
with C being a constant, ERUSD,i being the exchange rates with the ith currency and the USD, expressed as “this much of the foreign currency buys one USD,” and fraci is the fractional weighting of the ith currency in the basket. The product (Π) is taken for values of i between 1 and 6. All of the fraci add up to 1. The constant C is arbitrary but can set the value of the index at one point in time, often called the base period. In this case the constant was chosen to bring the index’s value to exactly 100 in March, 1973, which coincides with the time at which major currencies let their values float relative to one another. With all of the numbers plugged in it looks like this:
···USDX = 50.14348112 × EURUSD-0.576 × USDJPY0.136 ×
······GBPUSD-0.119 × USDCAD0.091 × USDSEK0.042 × USDCHF0.036
The exponents for the euro and the Pound sterling are negative because these exchange rates are usually quoted as dollars per euro and dollars per pound instead of euros per dollar and pounds per dollar. The euro makes up more than half of the weight by itself, and the euro, yen, and pound make up more than 83% of the weighting. This means that USDX is very sensitive to changes in the euro in particular. The index represents a relative vote of confidence by traders of the other currencies in the basket. As traders buy dollars, they compete for the available dollars and bid up the price denominated in the other currencies, which results in a rise in the USDX. Conversely, as they sell, the USDX goes down.
Traders are doing more selling of dollars than buying. A value of 71 for the index means that the USD has fallen to 71% of its value against the other currencies in the basket since 1973. It has yet to fall below 70 but that would be a troublesome psychological barrier to pass.
Anyway, I hadn’t bored you with equations in a while so there you go.
One Response to “How the US Dollar Index shows the strength of the dollar”
By Curt on May 5, 2008 | Reply
The dropping value of the dollar is a major problem that more people should be concerned about. The support for the dollar is fading about the world, and could soon collapse as foreign nations are sick of loosing money holding on to dollars. The only thing holding the dollar from collapsing is that oil is traded in dollars, so every nation need to have dollars to buy oil. But, that is changing as many nations talking about using other currencies to buy oil. Over the next few years, the dollar may enter the point of no return and American’s will suddenly find themselves a lot less wealthy. The wealth of our nation is definately as risk.