What’s a currency pair?
The foreign exchange market goes back over five hundred years. But the market that we all know today was established a mere 50 years ago, in the 1970s, even though before that, it had been a long time coming. From that moment forward, world currencies were no longer backed by gold, which meant they became commodities people could use to trade and invest in, overlooking their formal connection to gold. The trading world looks to U.S. dollars as the MVP of world currencies. Where once gold shone, U.S. dollars arose, making them dominant for the foreign exchange rate, effectively cornering gold on the market. The commodities rate is also largely determined by U.S. dollars. They include everything under the sun, from oil to cocoa to cattle.
So what is a currency pair? Simple: two currencies, with one acting as a commodity, and the other, as a measure of value. Basically, you use one to buy the other “commodity”, with both quoted against each other. The demand for “commodity” drives the foreign currency exchange rate. But don’t just take our word for it. Let’s dive into real-world examples. Take EURUSD: the EUR exchange rate is valued in terms of USD, that is, a euro consists of a particular number of dollars. If we look at USDJPY, then the exchange rate will give you the number of Japanese yen you will receive for every dollar you spend.
What’s Forex CFDs?
Okay, so currency pairs are pretty low-volatile as financial instruments. Basically, it means that price variation is not strong, making currency pairs popular amongst traders, as they have lower chances of drastic price movements. It is very rare for a currency pair exchange rate to rise/fall by more than one per cent in a trading day; it’s not unheard of, but it’s not something you see often. That’s why you might have noticed you’re not exactly swimming in money whenever it comes to exchanging currency at your local bank branch or FX trading: the amount of fees charged, or funds required will make you regret ever resorting to this type of making money.
Brokers are always looking to get more clients for FX financial products. So that’s exactly why they go down a different avenue: they trade forex Contracts for Differences (CFDs), with high leverage on currency pairs. That’s where the real money is. And that’s how they lure in clientele.
One thing that stands out the most here are lower fees and money that they have to spend: this major difference between simple FX trading and FX CFDs changes everything. You can profit from currency pair CFD leverage as currencies rise or drop through trades, i.e., buying and selling. But there’s more. If you’re ever in doubt about investing your own money, brokers have got your back: some offer trading in contracts whose size is a fraction of the corresponding contract, so you’re basically out of the woods here as you now have to invest much less of your FX money.
What factors affect foreign currency rates?
As you might have guessed, there are millions of factors affecting the price movements of foreign currency rates: you have your geopolitical factors, your economic factors, like GDP growth, and what have you. But the central banks are the main drivers behind the exchange rate. So you might want to look into their policies, because other factors, basically, can only predict what a policy is going to be about (and just how much it’s going to affect the FX rate). Central bank calendars are the Bible for an FX trader.
Inflation targeting is something that most central banks have to do and make public, which means that as inflation changes, so do a regulator’s decisions on the interest rate and afterwards, the value of money. It’s all virtually a big chain effect. Economic and geopolitical shocks can force a central bank to buy or sell currency directly on the market, a desperate move in an attempt to stabilise the national currency. But that’s not the only thing a central bank can do for the country’s currency: there’s always an option to induce exporters to sell foreign currency during the year.
Some countries may use a basket of currencies that are weighted against the national currency; this basket comprises the currencies of major trading partners. An index measures the value of a currency relative to a currency basket. You might have heard about the U.S. Dollar Index, the brightest specimen measuring the value of the dollar against a basket of euro, Japanese yen, British pound, Canadian dollar, Swedish krona, and Swiss franc.
We’ve already established that the major currency pairs traded comprise major reserve currencies including the U.S. dollar, which is a must in this case. But there’s more where that came from. There are also some currency groups that you need to know about:
- - minor currency pairs, a non-dollar financial investing instrument, where individual currencies are also majors, such as EURJPY;
- - emerging market currencies: let’s not forget about emerging markets, which have their own currencies, like Indian rupee, Mexican peso or Brazilian real.
FYI: If you really want to understand what’s happening on on the financial market, even if you’re not into forex that much, then you have to be in the know about capital flows on forex markets. The rule of thumb here is, it impacts other segments of the financial market greatly. So, for example, if an emerging market currency experiences a downturn, then you should expect other emerging market currencies to drop as well on account of investors making it a habit to invest in groups of countries, rather than randomly or in different-type currencies.
- - last, but not least: a currency group comprised of countries with strong resource-based exports: Canadian dollar, Russian rouble, Kazakh tenge, Venezuelan bolivar and Indonesian rupiah are all petrocurrencies, since these are oil-producing nations with considerable amounts of oil exports. Australian and New Zealand dollars also depend on their countries’ raw material exports.
Trading currency pairs: from A to Z
A currency pair features two currencies, so when it comes to investing, you need to factor in both currencies, as there are factors that might affect their exchange rate separately. Let’s take EURUSD. Whenever a trader buys, they buy euros for dollars; whenever they sell, then they sell euro and buy U.S. dollars, so it’s the exact opposite.
The important thing here to know is what and when a trader trades. So if you want to trade the New Zealand dollar or Japanese yen, remember to heed the Asian Forex Session: that’s when the magic (and business) happens. So this practically means you’re going to become a night owl if you’re in Europe at the time. Following that rationale, you can expect to deal in euro trades during the European Forex Session.
The American Forex Session adds liquidity; it determines the overall direction of price movements on the market, and that’s what a lot of investors keep their eyes on.
Trading currency pairs is a great option for beginner investors, as they are not as risky as other financial instruments, something that is attributed to the activities of central banks; with them, the market is less volatile. However, volatility can skyrocket, and so can risks, so watch out for significant news releases, like rate hike/drop decisions, inflation, GDP and unemployment data. There’s a thing called Employment Situation Summary, or a jobs report, which comes out in the U.S. on the first Friday of every month. The data featured in this report affects U.S. dollar-linked exchange rates if it differs significantly from market expectations.
So when a trader has various trades, all at the same time, they might want to keep an eye on the nature of all trades: when they buy EURUSD and USDCAD all at once, they shouldn’t lose focus since, as you understand, they buy and sell the dollar simultaneously. Within one group, such trades are counter-productive, as they do not foster a good financial result and are of different nature.
Cross-currency transactions also have higher risks, as they are more volatile than major currency pairs. That’s something to think about.