What Are Currency Pairs?

Markets have been volatile lately due to several underlying concerns. Still, one gathering headline is the blowup of the carry trade, where investors borrow in a cheap currency like the Yen and invest in a higher-yielding one like the U.S. Dollar.

Currencies play a significant role in global economics, and thanks to floating exchange rates, they can be traded on the foreign exchange (forex) market. How do currency pairs work? This article will explain how currency pairs function, what types are available and why investors pit currencies against each other in forex markets.

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What Is a Currency Pair?

Currency is the money used to facilitate transactions in an economy. It must be three things at once: a medium of exchange, a unit of account, and a store of value. While we mostly think of currency as the cash that pays our bills and buys our stuff, currencies can also be traded on the foreign exchange market – or forex.

Currency pairs are the fundamental units of the forex market. When investors trade on the forex markets, they’re trading two different currencies at once, hoping that one will appreciate against the other. Currencies from stronger economies will form liquid and stable pairs, while currencies from emerging market nations tend to be less liquid and more volatile.

How Do Currency Pairs Work?

When you trade a currency pair, you're speculating on whether the value of one currency will increase or decrease compared to the other. A currency pair has two key components: the base currency and the quote currency. The base currency is the first currency listed in the pair, and it's the amount you'll receive for a specific amount of the quote currency, which is the second part of the pair. 

For example, EUR/USD is the currency code for the pair representing the euro against the U.S. Dollar. It shows how many dollars you’d need to buy one euro. If you see a quote of 1.1000 EUR/USD, one euro is worth 1.1000 U.S. Dollars.  

Currency exchange rates fluctuate constantly due to the dynamic nature of global markets. Economic data, geopolitical events, interest rate differentials, and market sentiment can influence currency fluctuations. When the value of the base currency increases relative to the quote currency, the pair is said to be appreciating. Conversely, when the base currency's value decreases, the pair depreciates.

Types of Currency Pairs

Not all currency pairs are created equal. Some pairs are more liquid and efficient based on economic standing, currency strength, or political stability. Here are the different varieties of currency pairs and the benefits and drawbacks of each type.

Majors

The definition of a major pair can vary, but all investors and institutions generally accept four as majors.

1. EUR/USD (euros / U.S. Dollars)
2. USD/JPY (U.S. Dollars / Japanese yen)
3. GBP/USD (British pounds / U.S. dollars)
4. USD/CHF (U.S. Dollars / Swiss francs)

Major currency pairs are the most heavily traded currency combinations in the forex market. These pairs account for the lion's share of trading volume, making them highly liquid and influential in global financial markets.

What makes a currency pair a major? The heavy volume is driven by a combination of factors: economic significance, political stability, high liquidity, low spreads, and accessibility to traders from all over the world. And while major pairs can be volatile, they tend to move less erratically than minor or exotic currency pairs.

Minors

Minor currency pairs share many of the same characteristics as the majors but with one notable absence - the U.S. Dollar. Minor pairs include currencies from solid economies such as EUR/GBP, EUR/CHF and GBP/JPY. While the lack of USD in the asset pool limits some liquidity, minor pairs still have sufficient trading volume and wide-ranging accessibility.

But while there’s ample volume, the spreads tend to be higher, and execution speed isn’t as quick. Minor pairs also experience more volatility than major pairs in specific market environments, which can benefit experienced traders looking to profit from short-term economic events.

Exotic

Exotic currency pairs are formed by combining a major currency (like the U.S. Dollar, euro, or Japanese Yen) with the currency of a developing or emerging economy. These pairs are characterized by significantly lower trading volume than majors and minors, making them less liquid.

Trading exotics is risky for forex investors, with the potential for big profits and large losses. You must contend with low liquidity, high spreads, limited access and exotic pairs involving currencies from countries with political or economic instability. These pairs are often the most volatile assets on the forex market and are only recommended for traders with a high-risk tolerance.

Cross Currency

Cross currency is another way of saying a currency pair that doesn’t involve the U.S. Dollar. While cross-currencies offer opportunities for diversification and potentially higher returns, they also require a deeper understanding of the specific economic and political factors (as well as market sentiment) affecting the involved countries. Traders should carefully assess risk tolerance and conduct thorough analysis before trading cross-currency pairs.

Example of Trading Forex Currency Pairs

Let’s use EUR/USD as a forex trading example. Since EUR/USD is the most popular currency pair, liquidity will be high and spreads narrow, but you still need to research the position and enter at the proper time. 

Step 1: Research The Involved Countries

You’ll need to perform market analysis and develop a thesis for your trade. Forex analysis can include fundamental data like economic metrics (GDP, unemployment, inflation) and interest rates, as well as technical analysis to identify short-term support and resistance areas. 

Step 2: Set Up Your Position

Once you’ve performed due diligence, you must develop a trading position based on your market analysis. When trading forex, you’ll have two possible positions to take on a specific currency pair:

• Long Position (Buy): If you believe the euro will appreciate against the U.S. Dollar, you would buy the EUR/USD pair. This means you're buying euros and selling U.S. Dollars.

• Short Position (Sell): If you think the euro will depreciate, you would sell the EUR/USD pair, effectively selling euros and buying U.S. Dollars.

Setting up your trade also involves entry and exit strategies. Be sure to know what levels to set your stop-loss and take-profit orders at, as currency markets trade 24 hours per day during the week, and you’ll want to protect your positions while you sleep.

Step 3: Execute The Trade

Place your order through your forex broker's trading platform. Once you’ve entered your position, continuously track the EUR/USD pair's price movements and economic news. If market conditions change, be prepared to adjust your stop-loss or take-profit levels.

Forex trades involve leverage and transaction costs, so always fully understand your risks and obligations before opening a position. Also, keep an eye on market volatility and the economic calendars of the currencies' home countries. Ideal currency pair selection requires adherence to personal risk tolerance levels and individual investment plans.

Currencies Pairs Are The Main Assets of the Forex Market

Currencies are traded in pairs, meaning a forex trader is betting on two things simultaneously: one currency will appreciate against another (or vice versa). Forex traders can’t just hold USD and hope that its value increases; they must buy a pair like EUR/USD and hope that the U.S. Dollar increases in value VERSUS the euro.

Forex trading involves unique risks not found with assets trading on exchanges like stocks, ETFs, or options. Trading sessions are 24/5, leverage is applied on every trade and economic metrics and interest rates play a prominent role in fostering volatility. Be sure to consult with an advisor before entering the complicated forex world.

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