The Dollar Index DXY: What Is It?

In their attempts to assess the current and forecast the future state of the market, investors rely on a multitude of tools. This toolbox includes synthetic instruments such as stock market indices, which allow for an overall evaluation of the situation without the need to analyze numerous individual assets. Among the numerous indices used in the stock market, the Dollar Index stands out. What is it, and how can it be used in investments?

How the US Dollar Index Is Calculated?

In financial markets, the Dollar Index (DXY, USDX) refers to a synthetic instrument that shows the value of the American currency relative to a basket of six others:

  • Euro
  • British pound
  • Canadian dollar
  • Swiss franc
  • Japanese yen
  • Swedish krona

The selection of these currencies was not random – at the time of the index’s creation by JP Morgan in 1973, these currencies were the most significant in the US foreign trade turnover. Since then, the index’s composition has only been revised once when the German mark was replaced with the introduction of the single European currency.

The USDX is calculated as a geometrically weighted value of currency pair exchange rates:

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

The weight coefficients for the basket of currencies (exponents for each pair) were determined proportionally to their contribution to foreign trade operations. The first coefficient was chosen to bring the index value at the time of its introduction (following the Smithsonian Agreement, which allowed currencies to float) to 100%.

Thus, the dynamics of DXY effectively reflect changes in the value of the US dollar in the global market.

How to Use the Index in Trading

Today, traders in financial markets widely utilize the dollar index as a tool in various ways:

  • It serves as an indicator in currency trading (Forex).
  • It acts as a basis for derivatives in the futures market.
  • It forms the foundation for index exchange-traded funds (ETFs).

In the international currency market, the Dollar Index functions as a tool that helps assess the source of movements in currency pair quotes. For instance, when the EUR/USD pair is rising while the dollar index maintains a sideways movement, it can lead to two valuable conclusions:

The change in the exchange rate is driven by demand for the euro.

You can also pay attention to other currency pairs involving the euro, where similar developments are occurring.

Since the euro/dollar pair carries the most weight in the basket and, therefore, has the most significant influence on DXY dynamics, these assets typically exhibit a near-inverse correlation with a coefficient close to -1. In this situation, deviations from the standard pattern provide signals that are considered strong.

Another way to use the Dollar Index in currency market trading is to receive advance signals for instruments that are not part of its calculation. Indeed, major players who monitor USDX are prepared to react to its dynamics by opening corresponding positions in currency pairs. This, in turn, leads to changes in quotes, triggering a self-fulfilling prophecy mechanism.

The Dollar Index and Derivatives

Like any stock market index, the USDX serves as the basis for futures contracts in the futures market. The primary one among these is the futures contract on the dollar index, with the ticker symbol DX, which is traded on ICE (Intercontinental Exchange). ICE is a consortium of trading platforms from various countries that allows trading virtually round the clock.

The contract size for DX futures is 1000 times the current value of the index, and it expires quarterly in March, June, September, and December.

Trading the Dollar Index on the Stock Market

The Dollar Index also participates in trading on the stock market. For example, in the Arca section of the NYSE (New York Stock Exchange), there are three ETFs for which DXY serves as a basis or one of the underlying instruments:

  • UUP – PowerShares DB US Dollar Index Bullish ETF – mirrors the index’s structure when it is on an uptrend.
  • FSU – FactorShares 2X S&P500 Bull/USD Bear ETF – is based on the S&P500 during a bull market and the Dollar Index during a bear market.
  • UDN – PowerShares US Dollar Bearish ETF – is the opposite of UUP, replicating the index’s structure during a decline.

It’s not advisable to include these ETFs in your portfolio as primary investment tools. They are primarily designed for hedging, and it’s not easy to make a profit from them. However, they can serve as effective protection during turbulent times in commodity markets (especially in oil trading) and stock markets.

The Dollar Index and Securities

The Dollar Index, reflecting the value of the U.S. currency, can serve as a valuable source of information for investors in the stock market who deal with stocks, bonds, units, and other assets.

For example, the rise of the USDX indicates several important facts:

  • A decrease in the profits of global corporations that generate a significant portion of their revenue outside the United States.
  • A reduction in the competitive advantage of export-oriented American companies due to increased costs.
  • An increase in the price of investments in American markets (including securities) for foreign investors.

These factors suggest that the rise in the Dollar Index is a signal of a weakening U.S. stock market. This is confirmed by the correlation between the S&P500 and USDX, which is inverse, and its coefficient has significantly increased in recent years.

However, the situation is not entirely straightforward. The rise of the Dollar Index also indicates that the U.S. economy is growing (or recovering) at a faster pace compared to the global economy. Conversely, a weakening U.S. currency may signal problems in the country, which does not contribute to the strength of stock markets.

Therefore, when investing in stocks and other securities, analyzing the behavior of the Dollar Index can be very useful. However, since this instrument provides conflicting signals, it is necessary to conduct an analysis of the reasons behind this dynamic.