Explaining Currency Pairs in the Forex Market

    Currency pairs are the currencies of two different countries that are paired for trading in the foreign exchange, or FOREX, market. Each pair is associated with an exchange rate, which serves as the foundation for making a trading position.

All transactions within this market, whether they involve selling, buying, or trading, are done through currency pairs. Let’s do a deep dive into the role that currency pairs play inside the FOREX market.

Explaining the Base and Quote Currencies

In forex trading, currencies are exchanged in pairs; each pair consists of a base currency and a quote currency. For instance, in the EUR/USD pair, the former is the base currency while the latter is the quote currency. The latter is sometimes referred to as “counter” currency.

The concept of base and quote currencies can be best explained through exchange rates. For example, an exchange rate of 1.14020 shows that it would cost 1.14020 units of another currency to have 1 unit of this first currency (base). 

In terms of this example, having 1 EUR would require spending 1.14020 USD equivalently, to put it simply. Otherwise stated, the first one among a given pair is quoted in relation to the second one.

The Way Currency Pairs Work

The working mechanism of currency pairs lies in the changing rates of foreign currencies; these rates, referred to as floating rates, continuously change as a result of many factors.

 This means that currency pairs play a crucial role in determining how much one’s money would be worth if converted to another currency, and all these values keep on changing constantly. In every pair, one of them is always stronger than the other one.

The base currency determines foreign exchange rate calculations for currency pairs. A typical notation for currency pairs like EUR/USD 1.3045 indicates that the euro (EUR) is the base currency and the U.S. dollar is the quote currency. 

This notation establishes what is called a ratio or price, which shows how much of the quoted currency will be exchanged for one unit of the base currency. In this case, one euro could be converted to $1.3045, meaning this value is derived from the purchasing power of reference foreign money.

Based on this example, a trader would choose to go long on EUR and short on USD at the same time in order to make a profit from it. 

Euro must appreciate against other currencies so as to generate gains as claimed by Forex traders in this instance who sell Euros but not Dollar due to anticipation that dollar will be stronger than Euros. The changes in forex rates are commonly referred to as P.I.P. movements.

What are the major currency pairs?

The most heavily transacted currencies are the major pairs in the foreign exchange (FX) market. It currently consists of four major pairs: EUR/USD, USD/JPY, GBP/USD, and USD/CHF. 

These four pairs referred to as deliverable currencies belong to the Group of Ten (G10) currency grouping, which is a part of G10. In addition to their crucial role in facilitating economic transactions, they are also frequently traded for speculative purposes.

They play an important and central role in the global forex market since they have very high trading activities. 

Though traditionally confined to just four pairs, there is an ongoing debate on whether or not to make the USD/CAD, AUD/USD, and NZD/USD majors given that these three also belong to “commodity pairs.”

Among the pairs, EUR/USD generally has the largest trading volume globally, with over 20% of all FX activity. USD/JPY is far behind it, whereas GBP/USD and USD/CHF have smaller percentages of total global forex trade.

 It should be noted that the US. Dollar accounts for more than half of forex trades. Additionally, USD/CAD, AUD/USD, and NZD/USD frequently surpass USD/CHF and occasionally GBP/USD in terms of trading volume.

How are the prices for major pairs determined?

Currency prices are simply determined by supply and demand. This is due to the major currencies’ ability to float freely, and there are no restrictions in this case. Stability of prices may be interfered with by central banks when it is necessary to prevent excessive volatility that might have economic implications.

There are innumerable factors that determine what happens with demand and supply dynamics, such as economic fundamentals in each country, prevailing interest rates, future speculations regarding the nation’s economic growth and currency performance, as well as existing positions that will eventually need to be liquidated.

What are minor and exotic pairs?

Within the domain of foreign exchange trading, currency pairs that are not pegged against the US dollar are considered minor currencies or crosses. These generally have slightly wider spreads and lower liquidity than major ones but still maintain sufficiently liquid markets. 

Some of the most traded crosses belong to currencies known as majors, for example: EUR/GBP, GBP/JPY, and EUR/CHF.

Exotic currency pairs include those whose denominations originate from developing economies. Lacking in liquidity and with wider spreads, this is a feature of these pairs. A good example of such an exotic pair is USD/SGD (US dollar/Singapore dollar).

What are commodity pairs?

Forex currency pairs that emanate from countries with vast amounts of commodities are commonly referred to as commodity pairs or commodity currencies. 

This is due to the fact that these countries produce and export a wide variety of commodities, thereby making their economies very sensitive to any changes in oil or other commodity prices.

Hence, traders and investors who wish to speculate on price changes in commodities often take positions in these pairs, using them as alternative investments. 

Among the examples of this type of currency pair are USD/CAD, AUD/USD, and USD/NZD. Examples of such currencies also include RUB, BRL, and SAR, all of which are exposed to fluctuations in commodity prices.

Conclusion

Foreign exchange and currencies are set to play an increasingly key role in everyday dealings as financial markets constantly change and grow globally. 

Besides, notional volumes in this market segment already surpass a mean of $7.5 trillion daily. Thus, retail and institutional investors will continue to find numerous opportunities in converting for physical trade or using it as a strategic tool for portfolio diversification.