Does someone have a simple explanation of Trade Weighted index

Norman Bauer posted on Fri, Jun 15 2012 7:30 AM

rated by 0 users

Hello all, 

I am having a time comming up with a simple explanation of what dollar index (trade weighted index) is. First there is my limitation, as I am not that familiar with it. Second, the only definition I have is from WikiPedia which is a little vague. 

First question that comes to mind about the definition given below

"The Trade Weighted Index, also known as the effective exchange rate, is a multilateral exchange rate which is a weighted average of exchange rates of home and foreign currencies, with the weight for each foreign country equal to its share in trade. It measures the average price of a home good relative to the average price of goods of trading partners, using the share of trade with each country as the weight for that country."

Is this correct? If so then what goods is it comparing? Apples to apples or apples to olives? Would love a real world example that I can read up on.

Second question and it ties in to the first question. It seems from the search results that google generates on "trade weighted index", that goods have not bearing on the index. What I am concluding is that trade and goods are synomis with home currency rather than any commodities. Is this correct? 

Many thanks in advance for the clarification,

Norm

http://en.wikipedia.org/wiki/Trade_weighted_index

The Trade Weighted Index, also known as the effective exchange rate, is a multilateral exchange rate which is a weighted average of exchange rates of home and foreign currencies, with the weight for each foreign country equal to its share in trade. It measures the average price of a home good relative to the average price of goods of trading partners, using the share of trade with each country as the weight for that country.

The trade weighted index is an economic instrument used by economies to compare their exchange rate against those of their major trading partners. Those trading partners that constitute a larger portion of an economy's exports and imports receives a higher index. The trade weighted index is used to make a complete comparison between one economy's currency and other currencies it interacts with. It is a much more comprehensive analysis than comparing two currencies, for example, theAustralian dollar and the United States dollar.

The interpretation of the effective exchange rate is that if the index increases, the purchasing power of that currency is higher (the currency strengthened against those of the country's or area's trading partners). A lower index means that the currency depreciated (devaluation) so that you need more of that currency to pay for imports.