Part one: Basics of Currency Pairs

Part one: Basics of Currency Pairs

On a superficial level, Forex is just the process of changing one currency into another currency

Some of you have been involved in FX activities at some point in time – think about the first thing you do when visiting a foreign country (you change money, right?). But as with many other different things in the world, there is always more than meets the eye.

Our three-part guide on Forex Trading will cover essentials such as the FX market basics, currency pairs, terminology, and FX strategies. For aspiring traders, all these aspects can prove invaluable, especially during their initial educational process.

Without further ado, time to get started.

  1. What Is the Forex Market?

People trade currencies in a global marketplace called Forex. This market boasts an impressive feat: it’s the largest financial market globally, with a daily volume of $6.6 trillion, according to 2019 data. As there are no physical locations where investors buy and sell currencies, the FX market is decentralized.

What influences FX prices?

Many factors impact the Forex market, including interest rates, inflation, government policies, reports related to employment, gross domestic product (GDP), retail sales, Consumer Price Index, and many others.

In FX trading, price movements usually occur quickly, with transactions running one after the other in quick succession. Forex is a highly volatile market, prone to sudden shifts, which is also a blessing and a curse for traders since it can either exacerbate losses or boost winnings.

  1. How does the currency market work? When can you trade?

Currency trading typically occurs electronically over the counter (OTC), meaning that all transactions are mostly done by traders using computer networks. Because currencies are in high demand, the market is open for trading 24/5 worldwide.

From Sunday at 21:00 GMT (when Asian markets open) until Friday at 21:00 GMT (when U.S. markets close), people trade currencies in major financial centers, such as London, New York, Tokyo, Hong Kong, or Frankfurt.

  1. The basics of currency pairs

Definition of a currency pair – the base and quote currency

A currency pair refers to the quotation of two different currencies, with the value of one currency being quoted against the other.

In a pair, the first listed currency is the base currency, while the second one is the quote currency. Currency pairs compare the value of a currency to the other – the base currency versus the quote currency. Simply put, they indicate how much you need of the quote currency to get one unit of the base currency.

All currencies have ISO codes (three-letter alphabetic sequences) connecting them to the international markets: USD for the U.S dollar, EUR for the euro, GBP for the British pound, CHF for the Swiss Franc.

Types of currency pairs

In Forex trading, you will find three types of pairs: major, minor, and exotic.

The major pairs, which are the most traded, always include the U.S Dollar, and we have a total of 7: USD/JPY; AUD/USD; EUR/USD; GBP/USD; NZD/USD; USD/CAD, and USD/CHF.

The minor pairs include major currencies traded against each other, excluding the USD (AUD/CAD, EUR/CHF, GBP/JPY, and others).

Exotic currency pairs include one major currency and a currency from a developing or emerging market (EUR/NOK, USD/TRY, EUR/RON, and others).

  1. Spot Market and the Forward & Futures Market – The 5 Standouts

Apart from the FX market, there are many different financial markets derived from it, amongst which five stand out:

Foreign Exchange Spot (FX Spot)

The FX spot transactions require a settlement between two parts regarding the purchase or sale of currencies. FX spot transactions do not include interest, and their underlying currencies are physically exchanged following the settlement, which cannot exceed 48 hours.

The exchange rate used in the FX spot is called the spot exchange rate.

Foreign Exchange Option (FX Option)

Options belong to the derivatives category, which are financial instruments whose values are linked to underlying variables. Options give traders the right, but not the obligation, to exchange one currency for another at a pre-set price and date.

FX options trading also takes place over the counter (OTC). People use this market for both hedging (risk mitigation) and speculation, like leveraged products trading.

Foreign Exchange Forward (FX Forward)

FX forward contracts are agreements between two parts for predetermined transactions at a later date. The exchange of money occurs when the predetermined future date arrives, which differentiates forward contracts from other similar contracts.

Just like FX Options, Forwards can prove viable hedging solutions for risk management purposes.

Foreign Exchange Swap (FX Swap)

Foreign exchange swaps function as a simultaneous purchase and sale of the same amount of one currency for another.

The two involved parties swap principal and interest payments on a loan from one currency for principal and interest payment of a loan of equal value in the other currency. Currency swaps boast maturity dates of up to 30 years.

Foreign Exchange Futures (FX Futures)

An FX future describes a futures contract facilitating the exchange of one currency for another at a pre-set exchange rate and date. Traders use FX futures for both hedging and speculation purposes.

People trade FX futures on special exchanges, as they have a duration of up to 3 months. Note that futures contracts include interest rates, unlike spot.

3 key things to remember:

  • Forex is the biggest and most liquid financial market in the world, where people exchange currencies against one another.
  • There are many derivative FX markets, including Forward, Futures, and FX Swap, each with its pros and cons.
  • Investors get involved in Forex trading for several reasons, including hedging (as a protective measure against various risks) and speculation (on major world events or time-limited opportunities).

Sources: investopedia.com, thebalance.com, babypips.com, Wikipedia.com.

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