Understanding Currency Pairs and Currency Trading

A currency pair is a quotation featuring two different currencies, with currency being quoted in terms of the other. A currency exchange rate is always quoted in a currency pair, such as EUR/USD (Euro/U.S. Dollar). All currencies are assigned an International Standards Organization (ISO) code abbreviation which is often used to convey the particular currencies that make up a currency pair. For example, USD/JPY indicates two currencies: the U.S. Dollar and the Japanese Yen.

The first currency in a currency pair is referred to as the “base currency”, and the second as the “counter currency” or “quote currency”.
The value of the base currency is always 1. It is probably easiest to remember this by looking at a currency pair and saying “1 unit of the base currency buys how many units of the counter currency?”. Many currency pairs are expressed in terms of dollars, with $1 USD acting as the base currency (“how much of a currency does $US 1 buy?”). For example, a quote of USD/JPY 109.48 means that one U.S. dollar is equal to 109.48 Japanese yen.

A speculating trader buys a currency pair if he believes the base currency will increase with respect to the quote currency, or that the corresponding exchange rate will rise. Similarly, a speculating trader sells a currency pair with the hope that the base currency will decrease in value compared to the quote currency or the quote currency will increase with regards to the base currency.

Forex trading often involves the simultaneous buying of one currency and selling of another. Therefore, when you buy a currency pair, you buy the base currency and sell the quote currency. The “bid” is the price at which you can sell the base currency at the same time of buying the quote currency. The “ask” is the price at which you can buy the base currency at the same time of selling the quote currency. The bid price is always lower than the ask price. The difference between the bid and the ask price is referred to as the spread.

In currency trading, the most economically liquid and politically steady currencies are in higher demand than currencies based in less stable areas. Due to the size and strength of the United States economy, the American dollar is the world's most actively traded currency, and the U.S. dollar is normally taken as the base currency for quotes. The "majors" – the most liquid and most commonly traded currencies - are the U.S. dollar (USD), the Euro (EUR), the New Zealand dollar (NZD), the Canadian dollar (CAD), the Swiss franc (CHF), the British pound (GBP), the Japanese Yen (JPY) and the Australian dollar (AUD). Currency pairs that do not involve the U.S. dollar are referred to as “cross rates”. A “euro cross” contains the Euro in the currency pair.

When the U.S. dollar is the base currency and a currency quote goes up, it means the dollar has appreciated in value and the other currency has comparably weakened. In the previous exmple of Japanese Yen and U.S. dollars, if the USD/JPY quote increases to 110.60, then the dollar would become stronger since it is now able to buy more yen.

The three exceptions to this rule are the British pound (GBP), the Australian dollar (AUD) and the Euro (EUR). In these cases, a quote of GBP/USD 2.0574 implies that one British pound equals 2.0574 U.S. dollars. In these three currency pairs, where the U.S. dollar is not the base rate, a rising quote means a weakening dollar, as it now takes more U.S. dollars to equal one pound, euro or Australian dollar. In short, if the currency quote moves higher than the value of the base currency increases. A lower quote means the base currency is weakening.
By InvestorGuide Staff

Copyrighted 2016. Content published with author's permission.

Posted in ...