KEY TAKEAWAYS
- The trade-weighted dollar measures the USD's value based on trade partner currencies.
- It's vital for understanding the dollar’s purchasing power and international exchange.
- More currencies are used in the Trade-Weighted Dollar Index than in the USDX.
- The index is updated yearly based on U.S. trade data to reflect changes.
- Introduced in 1998, it includes 26 currencies representing 90% of U.S. bilateral trade.
What Is the Trade-Weighted Dollar?
The trade-weighted dollar is an index created by the Federal Reserve (Fed) to measure the value of the U.S. dollar (USD) based on its competitiveness versus trading partners.
Understanding the Uses of the Trade-Weighted Dollar
The trade-weighted dollar is used to determine the U.S. dollar's purchasing value as well as to summarize the effects of dollar appreciation and depreciation against foreign currencies. Imports to the U.S. become less expensive when the value of the dollar increases. Exports to other countries become more expensive.
The trade-weighted dollar is a measurement of the foreign exchange value of the U.S. dollar compared to certain foreign currencies. It gives importance and weight to currencies that are most widely used in international trade rather than comparing the value of the U.S. dollar to all foreign currencies. The currencies are weighted differently, so changes in each currency will have a unique effect on the trade-weighted dollar and corresponding indexes.12
The Evolution and History of the Trade-Weighted Dollar
The Trade-Weighted Dollar Index is sometimes called the Broad Index. It was introduced in 1998 in response to the implementation of the euro, which replaced many of the foreign currencies that were previously used in an earlier version of this index. It was intended to more accurately reflect current U.S. trade patterns.
The Fed selected 26 currencies to use in the index, anticipating the adoption of the euro by eleven countries of the European Union (EU).3
IMPORTANT
The Fed said in 2019 that the 26 represented economies accounted for about 90% of total bilateral trade with the U.S.1
Comparing the Trade-Weighted Dollar Index and the U.S. Dollar Index
The other primary index used to measure the strength of the USD is the U.S. Dollar Index (USDX). Created in 1973, the U.S. Dollar Index is composed of a basket of six currencies: the euro (EUR), Japanese yen (JPY), British pound (GBP), Canadian dollar (CAD), Swedish krona (SEK), and Swiss franc (CHF).4
The EUR is by far the largest component of the index. It makes up 57.6% of the basket. The weights of the other currencies in the index are:
- JPY: 13.6%
- GBP 11.9%
- CAD 9.1%
- SEK 4.2%
- CHF 3.6%4
The Fed hoped to create a better alternative to the USDX when it introduced the Trade-Weighted Dollar Index by using more currencies and periodically reviewing the index's composition. The Trade-Weighted Dollar Index includes countries from all over the world, and its weighting is updated once a year based on annual trade data published by the Bureau of Economic Analysis (BEA).1
What Is an Index?
An index is a benchmark measurement that gauges one investment's performance against another. It can be an invaluable tool for investors.
What Is Foreign Exchange?
Foreign exchange is the process of converting one country's currency to that of another country using a specified rate. The rates aren't stagnant. They move up and down regularly as influenced by supply and demand, so it can greatly help an investor to keep a diligent track of them.5
What Countries Make Up the European Union?
The European Union includes 27 countries as of 2024. They're all located in Europe, as the name suggests. They include Belgium, Italy, France, Germany, Denmark, Ireland, Sweden, and Finland. The United Kingdom left the EU in 2020. Ukraine submitted an application for membership in 2022 that's still pending.6
The Bottom Line
The trade-weighted dollar is sometimes referred to as the Broad Index. It was first introduced in 1998 in response to the implementation of the euro, which had replaced many of the foreign currencies that were being used in an earlier version of this index. The trade-weighted dollar was intended to more accurately reflect current U.S. trade patterns.
It measures the value of the U.S. dollar based on a comparison to the currencies of other nations. It focuses on those that are most commonly used in international trade, not those of all foreign nations. It gauges appreciation and depreciation and can be a valuable tool for those who engage in currency trading.
