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Building Currency Indices for Cross-Country Sentiment Measures

Article Quant Q&A · Author: damson_jam
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Summary

The question asks how to include exchange rates in a monthly investor sentiment index spanning the United States, the United Kingdom, China, Canada, Japan, and Australia. It considers using each country’s currency against the U.S. dollar, and asks what rate would represent the United States or whether all countries should instead use a common base currency. The motivation is that currency appreciation may reflect international demand for domestic assets, although that connection alone does not specify how to measure sentiment.

The response distinguishes an operational risk currency, used to consolidate and manage foreign exchange positions, from a currency measure intended for sentiment analysis. It suggests constructing a weighted index for each currency relative to the other currencies in the group, illustrating possible currency pairs for the included economies and noting the omission of the European Union. It also points to a dollar index as a possible reference. These are conceptual recommendations rather than a defined index recipe: no weights, normalization method, empirical validation, or treatment of exchange-rate direction is supplied. The proposed comparisons would need consistent construction before they could support cross-country interpretation.

Key ideas

  • A single base currency may serve inventory management but may not measure investor sentiment appropriately.
  • The response proposes comparing each currency with the other currencies in the country set.
  • A dollar index is mentioned as a possible reference for broad dollar movements.
  • An index design needs explicit weights and consistent treatment of exchange-rate quotes, which the response does not provide.
  • The response notes that the European Union is absent from the proposed country group.

Tags

ForexSentimentStatistics
Full text
# Choosing an exchange rate in a macroeconomic panel data set


# Choosing an exchange rate in a macroeconomic panel data set












I am constructing an investor sentiment index to determine the impact of investor sentiment on stock market crises. I am following the methodology in this paper, http://121.192.176.75/repec/upload/201312051625034821.pdf.

One of the components in the index is the exchange rate. The movement of exchange rate is closely related to international capital flows. A continuous appreciation of the domestic currency attracts more demand for domestic assets from international investors, leading to a higher investor sentiment index.

I am constructing the Index for 6 different countries; U.S., UK, China, Canada, Japan and Australia.

My question is: If I follow the method used in the paper and use the end of month national currency per USD (e.g. sterling per USD, Yen per USD etc..), what exchange rate should I use for the U.S?

Or should I use a common exchange rate for all 6 countries e.g. national currency per Euro?

Any help would be greatly appreciated.

Thanks

## Answer by rupweb (score 1, accepted)

https://quant.stackexchange.com/a/27707

Sounds to me like you're looking for something like the USD index, see https://en.m.wikipedia.org/wiki/U.S._Dollar_Index

As for a common exchange rate, sounds to me like you're looking for a "risk" currency which is the currency into which, if you managed FX inventories, you'd convert your trade flows. In other words using USD as a risk currency then you can choose to unwind your GBP, EUR, AUD positions to USD as they happen and then manage your long and short exposures in terms of USD rather than all currency instruments. Depending on competitive spreads that would work for managing inventories. I don't think it would really do for a sentiment index.

My guess for a sentiment index is to use a weighted index for each of your 6 currencies relative to the other 5. Also, in terms of "countries" you've missed out the EU.

In other words for EU make up an index of EURUSD, EURGBP, EURCNY, EURCAD, EURJPY, EURAUD.

For USD use EURUSD, GBPUSD, USDCNY, USDCAD, USDJPY and AUDUSD.

etc.

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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.