The US Dollar Index
The Dollar Index is a very useful yet simple to understand tool for currency, commodity and equity traders. The index measures the fluctuations of the US Dollar against a basket of different currencies: Euro, Japanese Yen, Canadian Dollar, British Pound, Swedish Krona and Swiss Franc. In practical terms, the Dollar Index tries to quantify how much the US dollar is appreciating or depreciating with respect to some of the most important and traded currencies in the world. The reason the Dollar Index is a valuable instrument for many traders is primarily due to its correlation to other asset classes and particularly risky assets. This HyperVolatility research will investigate how the dollar index relates to its own components.
As previously mentioned, the Index tracks the performance of the American dollar against a basket of other currencies, however, each exchange rate has a different weight. Specifically, the Index is a weighted geometric mean whose components and respective weights are the following: Euro (56.7%), Japanese Yen (13.6%), British Pound (11.9%), Canadian Dollar (9.1%), Swedish Krona (4.2%) and Swiss Franc (3.6%). The Index has 100 as a benchmark value therefore every reading below this threshold would imply a depreciation of the American currency against the basket, primarily the Euro, while any value above it is obviously indicating an appreciation. It goes without saying that the reason the Dollar Index has been trading below the 100 level for so long is the axiomatic consequence of the strength of the Single currency. It is clear that the Euro, whose weight in the Dollar Index calculation is 56.7%, is the most important currency since its impact is by far the heaviest. Obviously, every appreciation of the Single currency will impact negatively on the performance of the dollar and the next chart evidently displays such relationship:
The above reported chart evidently displays the natural inverse relationship between the 2 markets and the obvious contrary fluctuations can be used to hedge potential currency based portfolios. In particular, the Euro, which is considered to be a risky asset, is positively correlated to equity indices therefore a drop in the Single currency would automatically correspond to a rise in the Dollar index. However, the positive correlation amongst Euro futures and other equity indices (such as E-Mini S&P500, DAX or Nasdaq futures) would suggest that a down trend in the Single currency is likely to be accompanied by a retracement in many risky assets. Therefore, the Dollar Index, being a “contrarian market by default”, could be very useful to detect market nervousness and cover unstable positions in equities. In order to better understand how much the American currency is linked to its components we will analyze the volatility fluctuations of the most important exchanges: Euro, British Pound and Japanese Yen futures. The reason we chose these 3 currencies is related to their weights, in fact, the combination of the aforementioned asset classes is responsible for 82.2% of the Dollar Index’s oscillation (Euro 56.7% + Japanese Yen 13.6% + British Pound 11.9%).
The calculation tracks the volatility performance of the Dollar Index, Euro futures, Japanese Yen futures and British Pound futures. It is evident that the oscillations are more or less correlated, in fact, the volatility decreased for all asset classes in January, April — May, August — September and November — December but drastically augmented in February, June — July and October. Undoubtedly, every market behaved differently in the short term but the macro movements are very correlated each other. This information is very important to forex traders because it proves that the Dollar Index, in terms of magnitude, moves as much as the other currencies implying that it could be used as a hedging tool when the Euro or the British Pound are in downtrend (the behaviour of the Japanese Yen is different and it will be treated separately later on). Let’s have a look at the relationships amongst the aforementioned exchanges from a quantitative point of view:
The table presents the correlation and covariance of each asset class against the Dollar Index and the results stress what have been previously stated: the Index obviously has an extremely strong negative correlation to the price of the Euro (-0.93) and a strong negative correlation to the price of the British Pound (-0.66). However, Euro and British Pound volatilities display a strong positive connection to the Dollar Index, in fact, the correlation coefficients are +0.79 and +0.69 respectively. The positive connection in volatility is an obvious consequence of the fact that the rise in the Dollar Index will always be proportioned to the depreciation of the remaining currencies, hence, the movement will be fairly similar in terms of magnitude. The covariance of Euro and British Pound prices with respect to the value of the dollar (the covariance measures the mutual variability of 2 random variables) is negative, -0.16 and -5.04 respectively, which is another natural consequence of the appreciation of the American currency against European exchanges. On the other hand, the volatility covariance is positive, 1.95 and 1.73 respectively, implying that Euro and British Pound volatilities rise when the volatility of the Dollar Index rises and vice versa. The reason volatilities move in the same direction is because both markets observe a leverage effect process: the volatility tends to rise when the price action is in downtrend. Specifically, a drop in Euro and British Pound futures would probably cause an increase in market volatility but a rise in the Dollar Index would increase its volatility too. In other words, risky assets such as Euro or British Pound futures follow a leverage effect process while the Dollar Index is governed by an inverted leverage effect: the volatility increases with a larger buying pressure and decreases in case of a sell–off. Consequently, If Euro and British Pound futures are plunging they are effectively depreciating against the Dollar. Therefore, the volatilities of the 2 European asset classes, following a leverage effect process, will increase while the appreciation of the Dollar will push the Dollar Index up and the buying pressure would increase its variance too.
The Japanese Yen, instead, needs a different approach. First of all, it is necessary to remind that the Asian currency is often used as a hedging tool in portfolio management because many market participants rush to buy Yen when equities drop. Secondly, it is important to point out that the “safe haven role” played by the Japanese Yen has a clear implication: the volatility rises when the market heads north (if you are interested in hedging portfolio risk you may want to read the HyperVolatility research entitled “Portfolio Hedging: Risky Assets vs Safe Havens”). As we can see, Japanese Yen futures, as well as the Dollar Index, are popular assets when equity indices and single stocks are plummeting and their volatilities are both driven by an inverted leverage effect process. The positive price correlation between Dollar Index and Japanese Yen futures (+0.10) and the weak covariance (-0.26) evidently proves the point just made. The price correlation is clearly very low and the negative, although feeble, covariance indicates that the buying pressure was sometimes stronger for the Asian currency. The numbers suggest that in 2012 the Dollar Index and Japanese Yen futures have been both used as a hedging tool but in a diverse fashion because the buying pressure was evidently different.
Conclusions
The Dollar Index is a very simple to understand tool for traders and it is worth monitoring when investing. Here are some important points to bear in mind:
1) The benchmark value for the Dollar Index is 100. If the Index is below this level the dollar is depreciating against other currencies while a reading above this threshold implies an appreciation of the American currency
2) The Dollar Index is a weighted geometric mean whose components and respective weights are the following: Euro (56.7%), Japanese Yen (13.6%), British Pound (11.9%), Canadian Dollar (9.1%), Swedish Krona (4.2%) and Swiss Franc (3.6%)
3) The Euro is the currency that influences Dollar Index’s fluctuations the most
4) The volatility of the Dollar Index rises with an increasing buying pressure and decreases when the market goes down
5) Euro, Japanese Yen and British Pound are responsible for the 82.2% oscillations in the Dollar Index
6) The Dollar Index can be effectively used to hedge positions in Euro and British Pound futures
7) Japanese Yen futures do not show much correlation to the Dollar Index because of their “safe haven” characteristics
8) The Dollar Index, given its “contrarian nature” is a rather good asset to hold when risky assets (equities, stocks, etc) plunge
Check also the following researches:
“Commodities and Currencies: Inter-Market Analysis”
“Commodity Volatility Indices: OVX and GVZ”
“Trading Gold & Silver: A Realized Volatility Approach”
Visit HyperVolatility for more quant researches
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