Understanding Currency Pairs in Forex

What is a Currency Pair?

As the name suggests, a currency pair consists of two currencies: A base currency and a quote currency. For example, Europe's shared currency and the U.S. dollar make up the EUR/USD, with the euro acting as the base currency and the dollar as the quote currency (note that the quote currency can sometimes be referred to as a term currency). Three categories largely comprise currency pairs: majors, minors, and exotics. Majors are the most traded pairs in the foreign exchange market as they contain the most liquid currencies.

• Base Currency:

The base currency, the transaction currency, is the first currency appearing in a currency pair: the EUR, as shown in Fig. 1 A. This is also the currency traders or investors buy and sell when the pair is traded.

• Quote Currency:

The quote currency is the second currency listed in a currency pair: the USD, as in Fig. 1 A. The quote currency informs investors of the price to buy or sell one unit of the base currency.

As an example, using figure 1 A, to purchase one unit of euro (1 euro is the base currency), it would cost (using the quote currency) \$1.1087 (this is your ask price, the price at which traders always buy from). To sell one unit of currency, again using figure 1 A, you would need to sell one unit of the base currency (euro) at the bid price (which is the price traders always sell [short] from) \$1.1086.

As a reminder, in any currency pair, the first currency will always represent the base currency and refer to one unit, and the second listed currency will always refer to the quote currency.

The spread is the difference between the bid and ask prices, and the formula for calculating the spread is shown in Fig. 1 A. at the bottom: subtract bid and ask prices.

Among market participants, currencies over time have welcomed their own nicknames, which can be particularly important to understand when discussing the markets with other traders and investors. Below is a list of frequently used nicknames for currencies:

• The U.S. dollar: Greenback, buck, smackeroo, loot.
• The British pound: Sterling, quid, nicker, dosh, bread.
• The euro: fiber.

If that was not enough to confuse you, the following are some of the currency pairs' nicknames:

• EUR/GBP (Euro/British pound): Chunnel.
• GBP/USD (British pound/U.S. dollar): Cable.
• USD/JPY (U.S. dollar/Japanese yen): Ninja

Major Currency Pairs:

Major currency pairs represent the most widely traded and liquid currencies in the world: U.S. dollar (USD), Euro (EUR), Japanese yen (JPY), Pound sterling (GBP), Australian dollar (AUD), Canadian dollar (CAD), Swiss franc (CHF), and the Chinese renminbi (CNY).

Below are 8 major currency pairs consisting of the previous currencies:

1. EUR/USD (Euro/U.S. dollar)
2. USD/JPY (U.S. dollar/Japanese yen)
3. GBP/USD (British pound/U.S. dollar)
4. AUD/USD (Australian dollar/U.S. dollar)
6. USD/CNY (U.S. dollar/Chinese renminbi)
7. USD/CHF (U.S. dollar/Swiss franc)
8. USD/JPY (U.S. dollar/Japanese yen)

• United States Dollar

Major currency pairs will always include the USD. It remains the most globally dominant currency in the FX space. Many exchange rates are heavily influenced by the U.S. dollar. There is, however, speculation that gold or Bitcoin may replace the U.S. dollar as the world's reserve currency at some point. Though, this is all speculation, as it would not be easy; some even believe the Chinese yuan may also be a candidate (Frisby, 2022).

• Euro

The euro is the second-most traded major currency and the official currency of the European Union (EU). The average daily trading volume of the euro is over US\$1.1 trillion. According to Economy and Finance, the European Central Bank (ECB) is responsible for its issuance.

• Japanese Yen

The Japanese yen, boasting a daily average volume of US\$554 billion and representing the third most traded currency, is also the third-largest reserve currency. It is estimated that it accounts for around 4.9% of the world's currency reserves. The strength of Japan's economy, particularly its industrial sector, which manufactures exports such as automobiles, electronics, industrial equipment, ships, and textiles, has a substantial impact on the yen's value.

• Pound Sterling

The pound sterling is the official currency of the United Kingdom and its territories and the fourth most traded currency globally, with a daily average volume of nearly US\$422 billion. It is also the fourth-biggest reserve currency, estimated to account for 4.5% of global reserves by value. The pound’s value depends mainly on the UK’s economic performance, with inflation rate data, the Bank of England’s (BoE's) monetary policies, GDP, and employment reports all likely to have an effect. In recent years, its valuation has also been impacted by the United Kingdom's shifting connection with Europe: the country chose to leave the European Union in a referendum on June 23rd, 2016.

• Australian Dollar

The Australian dollar is Australia’s official currency. It is the fifth most traded currency in the world, with an average daily volume of US\$223 billion, and is the fifth most-held reserve currency.

The Canadian dollar is the country's national currency for Canada and the sixth most traded currency in the world, with a daily average trading volume of US\$166 billion. At 2.02% of worldwide reserves by value, the currency is the sixth most often kept reserve currency.

• Swiss Franc

The Swiss franc, the national currency of Switzerland, is one of the most powerful currencies in the FX market, and a considerable number of global corporations have established headquarters in Switzerland and are listed on the Swiss stock exchange as a result of the country's relatively low corporate tax rate and open economic climate. These actions increased the nation's current account and trade deficits and is rated the seventh reserve currency.

• Chinese Renminbi

The Chinese renminbi is the official currency of the People’s Republic of China and the eighth most traded currency globally, accounting for a daily average volume of US\$142 billion. Despite being an emerging market currency, it is also the seventh most-held reserve currency, estimated to account for 1.23% of global reserves.

Minor Currency Pairs and Crosses:

Pairs, which include any two of the major currencies except the U.S. dollar, are known as ‘cross-currency pairs’ or simply "crosses."

Importantly, crosses are also known as "minors." While not as frequently traded as the majors, the crosses are still liquid and provide trading opportunities. For classic trend trading, the most preferred and said to be the best to trade are currency pairs with the yen: EUR/JPY, GBP/JPY, AUD/JPY, and NZD/JPY. To the surprise of many, the Japanese yen has been the most steady currency pair during the past three years.

Minor Currency Pairs:

• EUR/GBP
• EUR/JPY
• GBP/JPY
• CHF/JPY
• EUR/AUD
• NZD/JPY

Factors that Affect Rates of Currency Pairs:

• Inflation:

Inflation measures the average change in prices for goods and services over a specific time period. Inflation refers to the general rise in prices, while disinflation refers to a slowing inflation rate: the rate is still rising but at a slower pace. Increased inflation in a country can weigh on its currency as it decreases the currency’s purchasing power against peer currencies. High inflation in the UK, for example, means that the prices for goods and services increase quicker than peer countries. And what this can do is reduce demand for UK goods/services (exports) and, by extension, reduce demand for the British pound.

However, traders and investors must consider the relationship between inflation and interest rates as consistently higher inflation often leads to interest rate increases which can support the currency.

• Interest Rates:

Interest rates have always affected the movement of currencies. Expectations and interest rate changes made by central banks can determine clear trends. One such example is the U.S. Federal Reserve recently raising its benchmark rate in 2022 and the Bank of Japan (BoJ) remaining on hold. This created a policy divergence and thus helped underpin the USD/JPY currency pair.

• Politics:

Research has shown that world leaders can influence Forex rates. As a result, when Donald Trump took office, we saw high levels of volatility in a number of currency pairs. For example, when Donald Trump fired James Comey as the Director of the FBI while he was investigating ties between Russia and Trump, shortly following the announcement, there was elevated volatility seen across the Forex market.

• Economic data:

Economic data are released daily and often have an immediate effect on the Forex market. These statistics primarily assess a country’s health and consist of inflation, employment levels, and the Gross Domestic Product (growth data).

• Select a Broker:

Choosing a good brokerage is imperative when trading the currency market. FP Markets is a good all-around broker that started in 2005, has numerous industry awards, is multi-regulated, offers over 70 currency pairs, has a choice of trading platforms, good customer service, and much more.

• Use a Demo Account

Even seasoned traders adopt demo trading accounts to familiarize themselves with new trading platforms and forward test new ideas and strategies. A demo account is offered for a reason!

Without a trading plan, you are trading blind. It will contain the trading strategies rules and also include things like risk and money-management strategies.

A good risk management strategy is crucial. Educate yourself regarding protective stop-loss orders and take-profit orders. Without sound risk management, trading can be a particularly challenging endeavour.

• Develop Trading Abilities and Skills:

Depending on your degree of expertise, it could take months or even years to master trading currency pairs to trade effectively. There is an abundance of freely accessible material on the internet. For example, FP Markets has a training academy of the highest caliber.

• Define Objectives:

Determine goals and devise and adhere to a trading plan to achieve them.

• Maintain a Paper Record and Journal:

Keep a journal in which every trade made is recorded, including why the trade was made, the dates, times, market conditions, and of course, the outcome. Keeping accurate records will be invaluable later when deciding if mistakes were made.

• Emotions:

Treat a demo account as real money because emotions will kick in when using your hard-earned cash. It's easier said than done to control emotions, so start doing so with a demo account.

• Commitments:

After fulfilling your obligations, invest only with money you can afford to lose. Don’t believe all the ads on the internet, which are full of false promises. The key is research, study, practice and, perhaps most importantly, patience.

Next Steps:

Consider opening a Forex and CFD trading account with a trusted Forex broker, such as FP Markets. Choose from our Raw and Standard account offerings and begin to explore the markets using our dedicated demo accounts.

References:

Frisby, D. (2022, December 6). Gold or bitcoin: what will replace the US dollar? | MoneyWeek. MoneyWeek. Retrieved February 5, 2023, from https://moneyweek.com/

The Euro: A Global Currency. (n.d.). Economy and Finance. Retrieved from https://economy-finance.ec.europa.eu/eueconomyexplained/euro-global-currency_en#:~:text=The%20euro%20is%20the%20second,lower%20costs%20for%20EU%20firms.

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