Bloomberg Correlation Weighted (BCW) Currency Index∗

Philip Brittan, Peter Carr, and Liuren Wu

Bloomberg LP

February 17, 2010

1. Background

The exchange rate fluctuation reflects the variation in the relative strength of the two underlying currencies.

The purpose of constructing a currency index is to extract the strength of a particular currency, which we

label as the host currency, by combining the movements of exchange rates that involve this host currency

and other currencies. As an example, if the euro, pound, yen, and Swiss franc prices of the US dollar are

all going up at the same time, we can say that the dollar is strengthening; on the other hand, if the price

of the dollar is going up in some currencies, but going down in others, the movements reflect more of the

other currencies than the dollar. Thus, by averaging the movements on prices of the dollar in many different

currencies, we can gauge the variation in the strength of the dollar.

In the late 1970s, the Federal Reserve constructed a major currency dollar index on a basket of ten cur-

rency pairs. The components and weights of the basket are determined by the amount of imports and exports

between the US and these other economies, as well as the the trades in between these other economies. The

ten currencies have now reduced to six as five of the currencies have become part of the euro. They are

the euro, the Japanese yen, the British pound, the Canadian dollar, the Swiss franc, and the Swedish Krona.
∗ The proposed index construction has benefited from discussions with Bruno Dupire, Gheis Hamati, and Arun Verma. We are

grateful to Gheis Hamati for leading the effort in putting the BCW index into production at Bloomberg. Patent pending.

1
The weight on euro has become exceptionally high due to the combination of the different currencies within

the euro zone and because of the high amount of trades within the euro zone. The Bloomberg ticker for

this dollar index DXY. As of February 9, 2010, the weight on euro for the DXY currency index is 57.6%.

Derivative contracts are currently traded on this contract.

In late 1990s, the Federal Reserve introduced a new set of dollar indices, where the components and

weights are adjusted in anticipation of the euro zone. In particular, trades within the euro zone are excluded

from the computation of the index weight. The weights are updated annually as the trade data are available

only quarterly. The new major currency dollar index contains seven currency pairs including the Australian

dollar. The weight on euro is not as high as that in the old dollar index (DXY) due to the exclusion of the

intra-euro-zone trades. The new dollar indices are published on the website of the Federal Reserve.

Deutsche bank currently also publishes indices on major currencies and economic regions. The con-

struction method is similar to that of the Federal Reserve in that it is based on international trade data. The

construction is further simplified by restricting to only five currency pairs for each index.

Since the idea of index construction is to average out the variation of the other currencies, using few

currency pairs in the index construction can lead to more volatile index movement. Furthermore, the index

value can deviate from the true underlying currency strength when the currency prices of other currencies

not included in the index move in opposite directions.

2. Our proposal

We propose to construct Bloomberg Correlation Weighted (BCW) currency indices to capture the move-

ments on major currencies. Our BCW currency indices have several distinct characteristics. First, the BCW

currency indices have a broader composition. Using fewer components make the index less representative of

the host currency as the variations of the few component currency can have large effects on the constructed

index. Using a broader base reduces the effect of a particular currency variation on the host currency under-

lying the index. Specifically, the BCW currency indices have positive weights on ten currency components:

2
the US dollar (USD), the euro (EUR), the British pound (GBP), the Swiss franc (CHF), the Japanese yen

(JPY), the Canadian dollar (CAD), the Australian dollar (AUD), the New Zealand dollar (NZD), the Swedish

Krona (SEK), and the Norwegian krone (NOK).

Second, we employ a completely new methodology in determining the weights of the components. The

new methodology does not use international trade data, but relies purely on the past time series behaviors

of the currency pairs. The objective is not to give more weight to a currency that has more trades with the

host economy, but instead to find the common movements among the different currency pairs, and to form

indices that explain the most variation in the ten currency pairs. The correlation-based statistical approach

also allows us to update the index weighting in a higher frequency than the quarterly or annual frequency

employed in previous indices. The weights on the BCW index components are updated daily.

In what follows, we discuss the details of the index construction.

2.1. The portfolio weight construction

At each date, we perform the following analysis under each of the ten currency denominations, and obtain

a set of weights for the ten economies under each currency denomination. Then, we average the weights

on each economy across the ten currency denominations to obtain one set of weights across all currency

denominations. The construction procedure is summarized in the flow chart in Figure 1.

1. Download historical data on the nine currency prices of the dollar: USDEUR, USDGBP, USDCHF,

USDJPY, USDCAD, USDAUD, USDNZD, USDSEK, and USDNOK. In the notation for the currency

pair, the first three letters denote the host currency under consideration, the last three letters denote

the numeraire currency. For example, USDEUR is the euro price of the US dollar.

With dollar as the host currency, we can think of a US investor investing in the ten currencies. Since

the dollar price of dollar (USDUSD) is always one, we can think of the investor’s dollar investment as

the cash and the investor’s investment in other nine currencies as risky investments, the risk of which

is captured by the variations of the nine exchange rates.

3
 Retrieve exchange rates (the value of dollar in ten currencies), P·1 :
[USD, EUR, GBP,CHF, JPY,CAD, AUD, NZD, SEK, NOK]

Repeat the following for each of the ten currencies

The value of h-th currency: P·h = P·1 /Ph1

Daily log return: Rtih = ln Ptih /Pt−1

ih , for i 6= h

2
Repeat Conditional variance update: Vtih = φVt−1
ih + (1 − φ) Rih
t−1 Repeat
for all for all
h: h:
1 1
p
Standardized return: SRtih = Rtih / Vtih
2 2
.. ..
. .
 
10 i jh i jh ih SR jh
= max 0, φSVt−1 + (1 − φ)SRt−1 10
Correlation update: SVt t−1 ,
i jh
i jh SVt
ρt = q
j jh
, i, j 6= h
SVtiih SVt

Compute the dominant eigenvector Uth and eigen-

i jh
value Dth from the correlation matrix C = [ρt ]

√ ih
Utih / Vt
Construct the weight from the dominant eigenvector:wtih = √ ih , i 6= h
∑9i=1 Ut /
ih Vt

Aggregate the computations for each of the ten currencies

Average the weight computed from each currency denomination:

10 ∑d=1 Dt wt
10 h ih
wti = 9 ∑10 Dth , i = 1, 2, · · · , 10
h=1

Real-time index updating based on daily updated weights

On-line update of the BCW index: Ith = It−1

h exp
∑10 i ih


i=1 wt Rt

Figure 1
The flow chart for the BCW index construction.

4
 When another currency is the host currency, the investment in that currency becomes cash investment

and investments in the other nine currencies become risky investments. Thus, we can extend the data

to 10 time series,

P·1 = [1,U SDEU R,U SDGBP,U SDCHF,U SDJPY,U SDCAD,U SDAU D,U SDNZD,U SDSEK,U SDNOK],

(1)

where the first series is the dollar price of dollar (USDUSD), which is universally one. When we want

to use any currency h as the host currency, we can simply perform the following transformation:

P·h = P·1 /Ph1 , h = 1, · · · , 10, (2)

with Ph1 being the host currency price of dollar. With any host currency h, the h-th column become

universally one as it becomes the price of itself.

2. For each of the ten host currencies h, for h = 1, · · · , 10, we perform the following operation:

(a) Construct the daily log return on each currency pair:

Rtih = ln Ptih /Pt−1

ih
, for i 6= h. (3)

Since the return on the cash position (Rhh ) is always zero. We exclude that particular column

from the return calculation and any of the following operations.

(b) Estimate the conditional variance of the daily log return on each currency pair at each date t. Let

Vtih denote the conditional variance on the daily return of the i-th currency pair on date t using

information up to day t − 1. The conditional variance is estimated and updated recursively daily

according to the following equation:

 2
Vtih = φVt−1
ih
+ (1 − φ) Rt−1
ih
, (4)

where φ controls the decay speed for past information. We set φ = 0.9991, corresponding to a

5
 half life of three years. To initiate the process, we set V0 to an unconditional variance estimate

for the whole initial sample period from January 1975 to November 2009. The effect of the

initial value declines gradually over time.

(c) Estimate the conditional correlation between daily log returns of different currency pairs. Let

ρt
i jh
denote the time-t conditional correlation between daily returns Rih and R jh based on infor-

mation up to t − 1. Given the conditional variance estimates, we first normalize the return on

each date by its conditional variance estimate,

q
SRtih = Rtih / Vtih . (5)

Then, we perform the following recursive estimation,

 
= max 0, φSVt−1 + (1 − φ) SRt−1
i jh i jh ih jh
SVt SRt−1 , i, j 6= h, (6)

again starting with an unconditional correlation estimate as the initial value. We constrain the

weights on all currency pairs in the basket to be positive. We achieve this constraint by con-
i jh
straining the conditional covariance estimate SVt to be positive.

The conditional correlation between the return pair (i, j) under the host currency h is given by

SVti jh
ρt
i jh
=q . (7)
j jh
SVtiih SVt

i jh
(d) From the time-t conditional (9 × 9) correlation matrix C = [ρt ], estimate the eigenvector Uth

corresponding to the largest (dominant) eigenvalue Dth of the matrix.

Let Utih denote the ith element of this eigenvector at time t. This eigenvector is the weight on

the standardized return SRt such that the portfolio ∑9i=1 SRtihUtih generates the largest conditional

variance. There are standard methods and commercial packages for calculating the eigenvalues

and eigenvectors of a matrix. For Bloomberg production, a routine with the following schematic

structure is implemented:

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 U=[ √19 ; √19 ; · · · ; √19 ]; sae=10;maxiter=1000;tol=5e-16;jj=0;
while (sse>tol) && (jj<maxiter) √
jj=jj+1; V=C·U; D=U·V; Unew=V/ sum(VV); sae=sum(abs(Unew-U)); U=Unew;
end
return {D,U}

Compared to many commercial packages, the above simple routine has the nice property that

in the extreme case when the correlation matrix C is an identity matrix and hence there is no

dominant eigenvalue, the routine stops at first iteration and returns the initial eigenvector U with

equal weights on all currency components.

(e) The weight on each of the nine currencies is given by

p
U ih / V ih
t t
wtih = p , i 6= h, (8)
∑i=1 Ut / Vtih
9 ih

where the weights on the nine risky currency investments are normalized to sum to one. We can

regard this as full investment (zero cash) normalization by setting wthh = 0.

3. Under each host currency, the above procedure produces nine weights on the other nine economies.

Going through the calculation on all ten host currencies generates nine weight estimates for each of

the ten currencies. We average the nine estimates to obtain one weight for each currency,

10 ∑10 h ih
h=1 Dt wt
wti = , i = 1, 2, · · · , 10, (9)
9 ∑10 h
h=1 Dt

where the average is weighted by the eigenvalue on each currency. Since there are only nine non-

zero weights for the ten currencies as one of them is cash, we use the (10/9) scaling to make the

investment approximately fully in the nine risky currencies. By using one set of weighting across all

index constructions, we maintain cross-sectional consistency and eliminate the remote possibility that

all currency indices go up or down simultaneously. In obtaining one weight for each currency, one can

either perform simple average or weighted average. Our preliminary analysis shows that the resultant

differences are small. At Bloomberg production, we choose the weighted average as in (9).

The weights on the ten economies are updated daily. The daily returns used for the weight construc-

7
 tion are based on Bloomberg fixings at 17:00 each day. For historical back-calculation when the

fixings are not available, we use BGN currency Last Price. The Bloomberg tickers for the weights are

“BCWWxxx Index,” where “xxx” refers to the three-letter name for each of the ten currencies: USD,

EUR, GBP, CHF, JPY, CAD, AUD, NZD, SEK, NOK.

2.2. The BCW index construction

The BCW currency indices are constructed as the cumulative investment profit and loss (ignoring interests)

in investing in the ten currencies based on the daily updated weights constructed in the previous subsection.

The Bloomberg tickers for the ten currency indices are “BCWIxxx Index,” where “xxx” denotes the three-

letter names of each of the ten currencies.

We normalize the levels of the indices to be 100 at January 2, 1975 and back-calculate the indices to that

date. Then, at any given time t, the index under each currency denomination is updated as follows,

!
10
Ith = It−1
h
exp ∑ wti Rtih , (10)
i=1

h denotes its previous updated level, wi denotes the prevailing weights level during the time interval
where It−1 t

and Rtih denotes the log return on the (ih)-currency pair over the time interval [t − 1,t]. Note that although

there are ten weights, only nine has a positive contribution because return on cash is zero, Rhh = 0, as

Phh = 1.

The portfolio weights wi are updated daily and calculated using daily returns based on 5pm Eastern time

fixings on the exchange rates. The weights are published at 5pm each day and the new weights are applied

to the index at 9am the next day. The weights calculated at 5pm Friday are applied Monday morning at

9am. The weights are rounded and published up to four digits (e.g., 0.1203). Given the weights in a day,

Bloomberg publishes fixings every two seconds on the component currencies and the indices. The indices

are published up to two decimal points.

8
3. Historical behaviors

Figure 2 plots the time series of the daily weights (BCWWxxx Index <GO>) on the ten currencies. Even

with the slow decay on the conditional covariance estimation, we still observe significant variations in the

weights over time. One notable trend is that since the early 1990s, the weight on the Japanese yen has been

declining while that on the euro has been increasing, suggesting that the yen movement is becoming more

idiosyncratic over time whereas the euro is becoming more dominant in the movements of the ten chosen

currencies.

Figure 3 plots the time series of the BCW currency indices for ten currencies (BCWIxxx Index <GO>).

Each panel is for one currency. Each BCW currency index time series (solid line) is compared with the

corresponding time series for the Deutsche bank index (dashed line). Since the Deutsche bank index is

available only from 2000 on, we normalize its value to match that of the BCW index at the first available

data point. For each currency, the two indices show significant co-movements during the overlapping sample

period, except for some abrupt adjustments in the Deutsche bank index for JPY, SEK, CAD, and NZD.

To see which index explains more of the component currency pairs, we take the common sample of

the two indices, and regress daily returns on the nine currency pairs on daily returns on the two indices

respectively. The R-squares of the regressions are plotted in Figure 4. Each panel is for one host currency.

The blue bars on the left are the R-squares from the BCW index, and the red bars on the right are the

R-squares from the Deutsche bank index. The blue bars are higher than the red bars for most cases.

9
 USD
EUR
GBP
CHF
0.15 JPY
CAD
AUD
BCW Index Weights

NZD
SEK
NOK

0.1

0.05

75 77 80 82 85 87 90 92 95 97 00 02 05 07 10 12

Figure 2
Time varying weights for the BCW indices.
The ten lines denote the weights (BCWWxxx Index) on the ten economies that we use to construct the BCW
indices.

10
 170
130
160

150
120
140
USD Index

EUR Index
110
130

120
100
110

100 90

90
80
75 77 80 82 85 87 90 92 95 97 00 02 05 07 10 12 75 77 80 82 85 87 90 92 95 97 00 02 05 07 10 12

100 280

95 260

240
90
220
GBP Index

CHF Index
85
200
80
180
75
160
70
140
65
120
60
100
75 77 80 82 85 87 90 92 95 97 00 02 05 07 10 12 75 77 80 82 85 87 90 92 95 97 00 02 05 07 10 12

450 150

400 140

350 130
CAD Index
JPY Index

120
300
110
250
100
200
90
150
80
100
75 77 80 82 85 87 90 92 95 97 00 02 05 07 10 12 75 77 80 82 85 87 90 92 95 97 00 02 05 07 10 12

100
110
95
100
90

85 90
AUD Index

NZD Index

80
80
75
70 70

65 60
60
50
55
50 40
75 77 80 82 85 87 90 92 95 97 00 02 05 07 10 12 75 77 80 82 85 87 90 92 95 97 00 02 05 07 10 12

110

100 105

90 100
NOK Index
SEK Index

95
80
90
70
85

60 80

50 75
75 77 80 82 85 87 90 92 95 97 00 02 05 07 10 12 75 77 80 82 85 87 90 92 95 97 00 02 05 07 10 12

Figure 3
The time series of the BCW currency indices.
The solid line in each panel plots the time series of a BCW currency index. The shorter, dashed line plots
the corresponding time series of the Deutsche bank index, which is normalized to match the BCW index
11
exactly at its first available point.
 0.9 0.7

0.8
0.6
0.7
R2, % from USD Index

R2, % from EUR Index

0.5
0.6

0.5 0.4

0.4 0.3

0.3
0.2
0.2
0.1
0.1

0 0
EUR GBP CHF JPY CAD AUD NZD SEK NOK EUR USD GBP CHF JPY CAD AUD NZD SEK NOK USD
0.8 0.7

0.7 0.6

0.6
R2, % from GBP Index

R2, % from CHF Index

0.5
0.5
0.4
0.4
0.3
0.3
0.2
0.2

0.1 0.1

0 0
USD EUR CHF JPY CAD AUD NZD SEK NOK USD USD EUR GBP JPY CAD AUD NZD SEK NOK USD
0.9 0.9

0.8 0.8

0.7 0.7
R2, % from CAD Index
R2, % from JPY Index

0.6 0.6

0.5 0.5

0.4 0.4

0.3 0.3

0.2 0.2

0.1 0.1

0 0
USD EUR GBP CHF CAD AUD NZD SEK NOK USD USD EUR GBP CHF JPY AUD NZD SEK NOK USD
1 0.9

0.9 0.8
0.8
0.7
R2, % from AUD Index

R2, % from NZD Index

0.7
0.6
0.6
0.5
0.5
0.4
0.4
0.3
0.3
0.2
0.2

0.1 0.1

0 0
USD EUR GBP CHF JPY CAD NZD SEK NOK USD USD EUR GBP CHF JPY CAD AUD SEK NOK USD
0.7 0.7

0.6 0.6
R2, % from NOK Index
R2, % from SEK Index

0.5 0.5

0.4 0.4

0.3 0.3

0.2 0.2

0.1 0.1

0 0
USD EUR GBP CHF JPY CAD AUD NZD NOK USD USD EUR GBP CHF JPY CAD AUD NZD SEK USD

Figure 4
Explained variation for the index composition.
The ten panels represent ten host currencies. For each currency pair in each panel, the bar on the left denotes
the percentage variation of that currency pair explained by the BCW index, and the bar on the right is the
12
explained variation for the Deutsche bank index.