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Econometrics: Interrelations between Equity, Currencies and Commodities Markets

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Econometrics: Interrelations between Equity, Currencies and Commodities Markets

The Dollar Index (USDX)• The U.S. Dollar Index consists of a geometric

weighted average of a basket of foreign currencies against the dollar.

• It's very similar to how the stock indices work in that it provides a general indication of the value of a basket of securities-other major world currencies

Let us have a look at the Basket…

The Basket• The U.S. Dollar Index consists of six foreign currencies.

They are the:• Euro (EUR)• Yen (JPY)• Pound (GBP) • Canadian dollar (CAD) • Krona (SEK) • Franc (CHF)

How Many Countries are included?

• There are 21 countries total, because there are 16 members of the European Union that have adopted the euro as their sole currency, plus the other five countries (Japan, Great Britain, Canada, Sweden, and Switzerland) and their accompanying currencies.

• The USDX is a good tool for measuring the U.S. dollar's global strength because many other currencies follow the U.S. Dollar Index closely

USDX ComponentsGeometric Weighted Average

The Composition• With its 16 countries, euro makes up a big

chunk of the U.S. Dollar Index-57.60%.• This followed by the Japanese yen-13.60%.• GBP-11.90%• CAD-9.10%.• SEK-4.20% and • CHEF-3.60%

When the Euro falls, where goes the USDX?

• When the Dollar rallies, EURUSD drops or falls• When the Dollar Index falls or drops,

EURUSD rallies• When USDX goes up, EURUSD goes

down and vice versa

USDX Daily Chart

EURUSD Daily Chart

How to Read the USDX

Reading the USDX• The Index is calculated 24 hours a day, 5 days a

week• It measures the dollar’s general value relative to

a base of 100.000• The start of the index was March 1, 1973 when

floated rates of exchange was allowed by the world’s biggest nations in Washington D.C.

• The start date of the index is also known as the base period

Reading the USDX cont’d• Let’s assume the current index reading is

84.600, USDX will be -15.40% (84.600-100.000). This means that the index has fallen 15.4% since start.

• And if the current reading is 117.912, the USDX will be 17.91% (117.912-100.000). This implies that the index has risen by 17.91% since start.

The U.S. Dollar Index Formula

• USDX = 50.14348112 × EUR/USD^(-0.576) × USD/JPY^(0.136) × GBP/USD^(-0.119) × USD/CAD^(0.091) × USD/SEK^(0.042) × USD/CHF^(0.036)

Putting all Together for FX Trading

• Always note that a breakout in the USDX will almost immediately give rise to a breakout in most USD pairs

• Always pay close attention to the position of the USD in whichever dollar pair you are trading to know what direction to move as USDX moves in a certain direction

• Example 1: If USDX goes up, EURUSD, GBPUSD, AUDUSD etc will go down. And if USDX goes down the will go up.

• Example 2: If USDX goes up, USDJPY, USDCHF, USDCAD etc, will go up

USDX Chart

USDCHF CHART

Always Remember…• If USD is base currency, e.g. USDCHF

then USDX and the pair will go the same direction

• If the USD is counter currency, e.g, EURUSD then USDX and the pair will go in opposite or inverse directions

The Dollar Smile Theory

• Stephen Jen, a former currency strategist and economist @ Morgan Stanley, came up with a theory and named it the "Dollar Smile Theory.“

3 Main Scenarios That direct the behaviour of the U.S. dollar.

The 3 Scenarios at playScenario 1 Risk Aversion

• Dollar appreciates due to risk aversion. The first part of the smile shows the U.S. dollar benefiting from risk aversion, which causes investors to flee to "safe-haven" currencies like the dollar and the yen. Since investors think that the global economic situation is shaky, they are hesitant to pursue risky assets and would rather buy up the less risky U.S. dollar regardless of the condition of the U.S. economy.

Scenario 2: USD Weakens to a New Low Due Weak Economy

• Dollar drops to new low. The bottom part of the smile reflects the lacklustre performance of the Greenback as the U.S. economy grapples with weak fundamentals.

• The possibility of interest rate cuts also weighs the U.S. dollar down.

• This leads to the market shying away from the dollar. The motto for USD becomes "Sell! Sell! Sell!“

Scenario 3: USD Strengthens Due to Economic Growth

• Optimism begins to pick as the US economy begins to show signs of growth. Expectation of strong GDP growth and future Interest Rate Hikes all move to stimulate the economy again, and the dollar begin to strengthen in the process due to foreseen economic growth

Warning!• It is important to note that all

economies move in cycles, and more important is knowing what cycle the economy you are focusing on is in

Getting your own USDX Indicator for META TRADER4 (MT4)

• Thank God we found one and included it in this package.

• It’s a custom indicator code written by