A currency pair is the value of one currency against another. For example, the EUR/USD is the most liquid currency pair in the world. The first listed currency of the currency pair, in this case the EUR, is the base currency and the second, the USD, is the quote currency.
The quote currency shows the amount of currency needed to buy the base currency. Take the example below, and you will see that USD 1.13001 is needed to buy one unit of EUR.
Another way of putting it: currency pairs can be considered a unit that is always traded in a pair that is either bought or sold. For example, with the EUR/GBP pair, you are exchanging a British Pound for the Euro, for a price.
Currency Pair Fluctuations
When we look at currency prices, or when we try to get the best rate, we notice that prices often change, and they do so quickly.
The value of currency pairs will fluctuate since they float continually in a market that is open five days a week, 24 hours every day. Simply put, it does not close.
It is important to remember that the foreign currency exchange is one of the largest and most liquid markets in the world with a daily global volume of $5 trillion.
You can doze off at night having benefited that day by a positive development, only to wake the next day to negative news impacting your investment. The market waits for no man or woman.
To get started, let’s develop a better understanding of currency pairs before we delve into the different types of currency pairs.
Making Sense of Currency Pairs
Let’s get to the basics: forex trading is the conversion of one currency into another with one currency always having a higher value than the other. Some currencies are volatile, as you will see below, others are more liquid and some others are based on global commodity prices.
For beginners, it is wise to start trading currency pairs with fairly low volatility, deep liquidity and volume and clear market fundamentals. These offer less risk as you begin your trading career. Read, educate and study the market before making a trade!
With that said, there are types of currency pairs to consider:
Let’s learn about each of them starting with majors.
Major Currency Pairs
There are seven major currency pairs:
They represent about 75% of all forex trades globally because they have the largest volume of buyers and sellers. The EUR/USD is the most liquid currency pair in the world, representing about 25% of the total forex transactions volume, while the USD/JPY is the second most traded currency pair at about 14% of the total.
The EUR and the USD are in demand because they are the currencies for the two biggest economies in the world. The USD/JPY is considered one of the safest currency pairs since Japan and the U.S., like the EU, have strong economies.
Appealing to Traders
Major currency pairs are appealing to traders.
Why, you ask? It starts with the volume – they have very high trading volumes. This makes it easier for traders to get in and out of positions because at any point there are other traders willing to buy or sell them.
These currency pairs are also relatively stable and strong, which makes them less volatile than others, and are influenced by supply and demand.
The final factor is the spread – they have tighter spreads. This gives them a higher profit margin compared to exotic and minor currency pairs. By fact, the more liquid an asset is, the tighter the spread.
We mentioned the importance of supply and demand in determining the value of major currency pairs. These factors can too:
- interest rates
- economic data
Commodities can also affect currency pairs. That is why there is a set of currency pairs that are called commodity currency pairs. And you guessed it, they depend on commodity prices, commodity exports and trade relations.
Cross (or minor) Currency Pairs
What distinguishes cross currency pairs from other currency pairs? They do not include the USD, which is the most liquid currency in the world and its primary currency reserve.
Examples of cross currency pairs are:
What are some of the benefits of cross currency pairs?
Traders have more opportunities to trade by adding dozens of currency pairs into their portfolio, rather than relying on USD, and it allows them to buy and sell the strongest and weakest currencies in the market.
It also makes currency trading less expensive because you don’t have to swap the currency into dollars first.
Cross currency pairs are mostly defined by their strong and interconnected economies. For those with a higher risk tolerance, there are the exotic.
Exotic Currency Pairs
An exotic currency pair includes a major currency and the currency of a developing nation, such as South African rand, the Turkish lira or the Mexican peso.
Emerging market currency pairs, or the exotic, such as the USD/TRY and USD/ZAR, have some of the highest volatility because of greater political and economic uncertainty.
Here is an example of volatility: the Turkish Lira devalued 40% against the USD in 2018 because of an extensive debt crisis and currency account deficit.
Exotic currency pairs are also less liquid and have higher spreads than major and minor pairs, which can reduce their profitability.
Given the risky nature of exotic pairs, experienced traders tend to trade them.
Commodity currency pairs fluctuate in value based on economic fundamentals, like economic growth, trade relations and demand for raw materials. The pairs include:
They represent countries with large amounts of commodity reserves, making the value of their currency highly correlated to changes in commodity prices, such as oil, beef, metals, wheat and wool.
Here are two good examples:
The AUD/USD usually rises when the price of gold increases, since Australia is one of the world’s largest gold producers, while the USD/CAD falls when the price of oil increases, with Canada’s position as one of the world’s biggest producers of oil.
Russia, Saudi Arabia and Brazil
The Russian Ruble and the Saudi Riyal can be impacted by oil prices. Why? They rank among the top producers and holders of crude oil reserves in the world. The Brazilian Real is considered a commodity currency because the South American country is one of the largest base material exporters in the world. The Peruvian Sol moves with copper prices. Why? Copper accounts for a significant portion of Peru’s exports.
Volatile Currency Pairs
Volatility is something that traders have to manage when they are dealing with exotic currency pairs. Unlike the major pairs, they are a lot less liquid, more susceptible to market fundamentals and internal economic and political changes.
Here are examples of some of the most volatile currency pairs.
Currency Pair Correlations
Whether it’s a major, minor or exotic, volatile or stable, traders can study currency pair correlation.
This is a measurement of how two currency pairs move in relationship to one another. For example, do the two currency pairs move in the same, opposite or totally random direction during a period.
There is a positive correlation, or when they move in the same direction, and a negative correlation, when they move in the opposite direction. These can be influenced by fundamental factors, including monetary policy and economic and political developments.
With positive correlation, the two currency pairs will move in the same direction with the same fundamental news. The GBP/USD and EUR/USD are often correlated positively because of the close relationship between the GBP and the EUR.
Examples of currency pairs that correlate positively:
- EUR/USD and GBP/USD
- EUR/USD and NZD/USD
- USD/CHF and USD/JPY
The common factor here – the currency pairs always have the same base and quote currencies.
The Negative Correlation
With negative correlation, you can also reduce your risk of exposure by picking currency pairs that have a negative correlation, where one currency goes up, the other will go down. This allows you to hedge against price fluctuations by offsetting the loss of one against the gain of another.
Examples of currency pairs that correlate negatively:
- EUR/USD and USD/JPY
- GBP/USD and USD/CHF
- USD/CAD and AUD/USD
The common factor here – the currency pairs always have the opposite base and quote currencies.
We have made our way through the different types of currency pairs – major, minor and exotic – available to trade for the beginner and the expert trader. We have learned that some currency pairs rely heavily on commodity prices, such as the AUD/USD, while others correlate positively because of strong economic ties between two countries.
Before making a decision to trade one currency pair or another, do your research on what suits your investment interests. The trading of some currency pairs clearly presents more risk than others. This is why the seven major currencies provide more stability with their higher liquidity and stability than exotic currencies.
Frequently Asked Questions
What is the difference between positive and negative currency correlation?
There is a positive correlation when two currency pairs move in the same direction. There is a negative correlation when they move in the opposite direction. These factors can be influenced by fundamental factors, including monetary policy and economic and political developments.
What is a foreign exchange rate?
It is the price of a domestic currency against another currency. It compares the value of one currency against the value of another. It is done so in pairs. These prices will change over time based on factors that affect currency prices.
What are some of the factors that affect currency prices?
Currency prices, like commodities and equities, are susceptible to market fundamentals. They include:
- Changing interest rates
- Negative economic data, such as slowing economic growth
- Political uncertainty
- Monetary policy
- War and international conflicts
What currencies are the most stable?
The general consensus among traders is that currencies with high liquidity, stable economies and robust supply and demand make for stable currencies. These include seven major currencies.
What is the foriegn currency exchange market?
The foreign exchange market is the largest and most liquid market in the world at about $5 trillion daily. It’s a decentralised and over-the-counter market where all the world’s currency exchange happens.
Do you have to use leverage when trading forex?
Not really. Some CFD brokers offer non-leveraged trading but that is very rare. To make any significant profit you would need a huge amount of capital.