Currency ETFs and Their Underlying Indexes – UUP, USDU

The PowerShares DB US Dollar Index Bullish ETF, UUP, is a currency fund; it provides inverse exposure to an index of USDX futures contracts that rises in value as the dollar appreciates relative to a basket of world currencies. The fund was established in February 2007 and has $591.32 million ten years later today.

U.S. Dollar Index is constructed on top of six currencies weighted against the U.S. dollar. It originally was developed by the U.S. Federal Reserve in 1973 to provide an external bilateral trade-weighted average value of the U.S. dollar as it freely floated against global currencies. The global currencies contain these six: the Euro, Japanese yen, British pound, Canadian dollar, Swedish krona and Swiss franc. Note that before the creation of the Euro, the original USDX contained ten currencies. In 1985, the ICE Futures U.S. took it over from the Federal Reserve to compile, maintain, determine and weight the components of the U.S. Dollar Index and calculate and disseminate it.

The U.S. Dollar Index is calculated with this formula: USDX = 50.14348112 × EURUSD -0.576 × USDJPY 0.136 × GBPUSD – 0.119 × USDCAD 0.091 × USDSEK 0.042 × USDCHF 0.036 U.S.  Each currency has a weight, Euro (EUR) 0.576, Japanese Yen (JPY) 0.136, British Pound (GBP) 0.119, Canadian Dollar (CAD) 0.091, Swedish Krona (SEK) 0.042 and Swiss Franc (CHF) 0.036 respectively. This index was adjusted once when the euro was introduced as the common currency. The price used for the calculation of the Index is the mid-point between the top of the book bid/offer in the component currencies.

This formula instantly raises a question on it’s fixed number of global currencies – six and fixed weighting scheme. Why? The economy is constantly changing and evolving, China is becoming increasingly important as a customer and supplier in worldwide business, India is rising, as a significant player in the economic landscape, ignoring currencies from such countries is obviously a denying of the reality. However, it’s just an important caveat for investors to be aware if they have a firm and clear view about Dollar movements relative to these six currencies in the future.

wisdomTree’s USDU the WisdomTree Bloomberg U.S. Dollar Bullish Fund (USDU) seeks to provide a dynamic and effective way of gaining exposure to the U.S. dollar against a basket of foreign currencies. It started in December 2013 with An AuM of $159 million. This fund is tracking the Bloomberg Dollar Spot Index (BBDXY). Distinctly different from UUP, USDU does not restrict itself from only the fixed six kinds of currencies, contrarily; it operates against a lengthy list of currencies including Chinese Yen, Korean Won, and other currencies from Emerging Markets.

Its methodology is as such: first, identify the top 20 currencies in terms of global trading activity versus the U.S. dollar (as defined by the Federal Reserve in its Broad Index of the Foreign Exchange (FX) Value of the Dollar); second, identify the top 20 currencies in terms of global foreign exchange volume (from the BIS Triennial Central Bank Survey); third, select the top 10 currencies of both lists after removing currencies pegged to the U.S. dollar (such as the Hong Kong dollar or Saudi riyal) and use average weights from each set Final Weighting; finally, capping the exposure of the Chinese yuan to 3% and distributing the extra weight to other currencies on a pro-rata basis, removing currency positions with weights of less than 2% and distributing their weights to other currencies on a pro-rata basis. The index is rebalanced on an annual basis each December; the Index reconstitutes to capture the current top currencies in terms of global trading activity and global FX volume.

For currency investors, it’s of crucial importance to understand the interest rate expectations, which is the primary driver of all currency movements.  In addition, it’s time worthy to understand how future, forwards are traded in the market and reflect this interest rate expectation.

The principal instrument in the currency market is a three-month non-deliverable forward, setting forth the currency forward rate between six and nine months. This forward rate divided by the nine-month rate produces a forward rate ratio (FRR6, 9). This ratio usually follows a pattern of LIBOR curve, in the sense, that if the ratio is greater than 1.00, the LIBOR curve is positively sloped and vice versa.

However, an extreme financial crisis like the 2008 sub-prime event and fabricated intervention such as Quantitative Easing will change the pattern. Under panic, the LIBOR, as well as the forward rate of U.S. dollar spiked 100 bps in August 2008, while under QE era; dollar interest rate is forced to be around zero.

Abnormality usually creates opportunities for wise investors.  At current time period, on a macroeconomic level, given Brexit occurred in June last year, then battleground reversed in French election indicated by the victory of open-policy Macron, the euro outlook is still quite vague and struggling. Japan is always actively attempting to weaken the yen through its aggressive monetary policy. China has been steadily promoting the inclusion of its currency into the international basket of currencies, but meanwhile still strict in opening up free trading of Renminbi. The Swiss franc does not have the global economic reach of other developed market currencies. In the domestic market, the Donald Trump regime always pump into the society somewhat optimistic resurrection of the economy by going more capitalism-guided.

Hence, the overall conviction is that the dollar is likely to appreciate in value against a broad basket of currencies.

Let’s observe the performance of these two ETFS in the past couple of years.

The chart below resonate with my view, in that, first, all three – UUP, USDU, and the U.S. Dollar Index are highly correlated. There is a surge of Dollar appreciation since January 2014, then plateaued and declined in the end of 2015, and since then, went through another slight up and down circle.


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