Trade-Weighted Exchange Rate

The trade-weighted exchange rate is the measure of a nation's currency exchange rate against that of another country based on the number of trades they involve in with each other. The primary purpose of this rate is to determine how a currency exchange rate changes on par with other currencies and help assess how strongly a currency stands in the global market.

The trade-weighted exchange rate index is an important economic indicator for the nation. There are certain weights assigned to different currencies. They help in determining the real value of domestic and international trade. Plus, it is helpful in imports and exports. However, the degree of trade may differ, causing an impact on the real trade-weighted exchange rate.

• Trade-weighted exchange rate refers to a measure of a country's currency value relative to a basket of other currencies, weighted according to each currency's importance in that country's international trade.
• The weights assigned to currencies in this exchange rate are based on their significance in a country's trade with different trading partners.
• The trade-weighted index comprehensively represents a nation's currency performance and impact on trade flows.
• Unlike bilateral exchange rates involving only two currencies, it considers multiple currencies to provide a broader perspective on currency performance in international trade.

The trade-weighted exchange rate is a weighted average of the home (domestic) currency with the foreign currencies. Here, every weight is assigned by the share held by the currency in the trade. Thus, more trade results in a more significant effect on the currency traded. Similarly, a minor trade cannot influence the real trade-weighted exchange rate. For example, using the US dollar in European countries will see an appreciation in its value. As a result, the weight assigned to it will also be heavy.

This index focuses on applying weights to the currencies involved in the trade. These weights can differ from nation to nation. They can be export-based, import based, or total-external-based. Also, to calculate the real trade-weighted exchange rate index, the geometric mean is used. The weighted average method gives an accurate overview of the currency's value compared to the traded foreign currency. It is vital to note that arithmetic mean is not used as it does not give a relative importance to each traded currency. In addition, it ignores the volume involved in that particular trade.

Depending on the scaling and usage factor, the weights are assigned. A nation with higher use in international trade will have a higher weight allocated. Likewise, the less-traded currency will have the least weightage in the calculation.

A US dollar trade-weighted exchange rate is also known as the Broad Index. Since its creation in 1973, twenty-six currencies have been under this basket. It includes the Japanese Yen (JPY), European Euro (EUR), Canadian dollar (CAD), British Pound (GBP), Swiss Franc (CHF), Swedish krona (SEK), and more.

Let us look at the formula to have a better understanding of the concept:

Let us look at the examples of how to calculate trade-weighted exchange rate using the mentioned formula above:

Example #1

Suppose four countries are in trade relations with the United States. It includes Japan, Germany, Mexico, India, and Canada. Each country involves either import or export with the domestic nation. So, with the help of the formula, the US performs the calculation. Let us look at it:

The following schedule mentions the countries along with the currencies and base period. Here, the base period remains to be 1997.

Calculation:

Trade-Weighted Exchange Rate = 100xΠe_iteiowit X  IND

= (139.25/107.80)^0.8943 x (0.94/0.94)^0.5331 x (56.13/9.46)^1.0887 x (82.51/43.50)^0.2345 x (1.34/1.4886)^1.2566 x 100

= (2.118) x (0.9715) x (4.8611) x (34.06) x (0.8146) x 100

= 277.51 x 100 

= 27,751. 

Example #2

Federal Reserve Bank of Kansas City examined various scenarios related to the trade-weighted exchange rate. One of the scenarios they considered was a "no change" scenario, where they assumed that the trade-weighted exchange rate would remain constant for the remainder of 2022 and throughout 2023.

Another scenario they analyzed was an "appreciation" scenario, in which they anticipated a moderate increase in the value of the US dollar by 5 percent until the end of 2023. Additionally, they explored a "depreciation" scenario, where they projected a slight decrease in the value of the US dollar by 2.9 percent until the end of 2023, based on a benchmark known as purchasing power parity.

Although bilateral exchange and trade-weighted exchange rate involves FOREX (foreign exchange), the currencies involved differ. So, do their differences. Therefore, let us look at their differences:

This article has been a guide to Trade-Weighted Exchange Rate and its Meaning. We explain it with its formula, comparison with bilateral exchange, & examples. You may also find some useful articles here -

• Nominal Effective Exchange Rate
• How Is Currency Valued?
• Spot Exchange Rate