In this tutorial, we would be learning about the concept of Currency Pair and Exchange Rate used in Forex Trading. We would dig down into some common questions such as What is Base Currency? What is Quote Currency or Counter Currency? What is Exchange Rate of Currency pairs? and various methods that are used to decide the Currency Exchange Rate.
What is Forex Currency Pair?
Before knowing about base currency and quote currency, let us first know about currency pairs.
A currency Pair is a structure of deciding quotation and pricing of the currencies traded in the forex market. And the value of a currency is a variance rate and is always determined by its comparison to another currency.
We already know that, in the forex market, the currencies are exchanged. As of current date, there are approximately 180 legal currencies circulating throughout the world. So it is theoretically possible to exchange a single currency with 179 different currencies.
So the question is that, how would we know which currency has been exchanged against which other currency?
To solve this confusion when buying or selling forex it is essential to mention those two currencies as a pair, one which we bought and another which we sold in order to buy the first one.
We generally denote currency pairs as follows: First Currency / Second Currency (for e.g.- EUR/USD).
Currency pairs are also categorized as Major, Minor, Cross-currency, and Exotic currency pairs which we would discuss later.
What is Base Currency in Forex Trading?
We already know that, in the forex market, currency units are quoted as a pair of different currencies (or Currency Pairs).
The Base Currency (also called the Transaction Currency) is the First Currency mentioned in a currency pair quotation.
For example: If some currency pair is written as XXX/YYY or simply XXXYYY. Here, XXX is the Base Currency. Sample formats are as follows: EUR/USD, EUR/GBP, AUD/USD.
If the currency pair is EUR/USD (like the image below) then the base currency is EUR.
What is Quote Currency or Counter Currency?
The second currency noted in the currency pair is called as the Quote Currency or Counter Currency.
It is often used as a reference to measure the value of the first currency (base currency).
For example: If some currency pair is written as XXX/YYY or simply XXXYYY. Here, YYY is the Quote Currency or Counter Currency. Sample formats are as follows: EUR/USD, EUR/GBP, AUD/USD.
If the currency pair is EUR/USD (like the image shown above) then the quote currency is USD.
What is Exchange Rate of Currency Pairs?
Forex trading is viewed as the simultaneous buying of one currency and selling some other Currency. For example, when a buyer purchases EUR/USD, it basically means that he is buying EUR and selling USD at the same time.
The Exchange Rate basically indicates how much of the quote currency is needed to be sold to buy one unit of the base currency.
The Exchange Rates are generally denoted as follows:
First Currency / Second Currency = Exchange Rate.
Base Currency / Quote Currency = Exchange Rate
Reference to the above image as an example:
At time of buying the base currency (here EUR), reading EUR/USD = 1.18 means that in order to purchase 1 EUR, a you must pay 1.18 US Dollar.
In the same way, at time of selling base currency if we read EUR/USD = 1.18, It means that you will get 1.18 USD if you sells 1 EUR.
These Exchange rates are fluctuated based on which currency is stronger at the moment and creates an opportunity for traders to gain profit.
How is the Currency Exchange Rate decided?
There are three types of methods in which countries decide exchange rates of their currencies.
- Pegged rate
- Managed Floating Rate
This event takes place when a country chooses not to issue its own currency and adopts a foreign currency as its domestic currency.
Though dollarization typically enables a nation to be considered as a better place for investment, the drawback is that the nation's central bank can no longer print money or make any kind of monetary policy.
An example of dollarization is El Salvador accepting the USD as national currency.
2) Pegged Rate:
Pegging takes place when one country directly specifies its exchange rate to a foreign currency so that the country's currency will get somewhat more stability than a normal float.
More specifically, pegging grants a country's currency to be exchanged at a fixed rate with a single or with a range of foreign currencies. The currency will only fluctuate when the pegged currencies change.
An Example of this is when China pegged their currency with USD to maintain a fixed exchange price.
3) Managed Floating Rate:
This is by far the most adopted mechanism for deciding exchange rates.
This type of system is adopted when a currency's exchange rate is allowed to change freely depending on economic forces of demand and supply. However, the government or central bank may still intervene to stabilize intense fluctuations in exchange rates.
For example: if positive news about a certain region hits the markets, it will boost investment and increase demand for that region’s currency. Unless there is a synchronous increase in currency supply, the disparity between supply and demand will result in an increase in exchange price. Similarly, a negative news can cause investment to decrease, successively lowering a currency’s price.
We hope that you have enjoyed the above article describing the base currency, quote currency, exchange rate, and currency pairs. Be with us to explore forex trading, stocks trading, and other money-making opportunities.
Leave us some comments if you have any questions or you need any more information on the above topics. Also, let us know what is your favorite base currency and quote currency.