Understanding exchange rates can appear difficult at first sight, especially if you’re new to forex trading.
But fear not! These mysterious looking streams of figures are actually really fairly straightforward, and it shouldn’t take you long at all to get used to understanding what the currency price information you see on your screen means once you have grasped a few basics.
This helpful guide explains everything you need to know to understand foreign exchange rates and trade with confidence.
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Currency Prices are Quoted in Pairs
The price of a currency (such as the Euro, for example), is always described in terms of another currency. If you think about it this has to be the case – you can’t say how much a Euro is worth in Euros – the price will always be 1 because 1 euro is always worth 1 Euro!
So the price of a Euro must always state how much it is worth in a different currency. Currencies prices are quoted in pairs, such as EUR/USD, which is the value of one Euro in US Dollars. Using this pair as an example, let’s look at a price quote for this pair.
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EURUSD = 1.2259 |
The quote you see above means that 1 Euro can be exchanged for 1.2259 Dollars.
The Euro is the base of the pair above because the price quote is based upon what one unit of it is worth. But what is 1 Dollar worth in Euros? We can work this out by dividing 1 by the price quote we saw above:
1 / 1.2259 = 0.8157
A Dollar is therefore worth 0.8157 Euros.
Here we are using the Dollar as the base for the pair, so theoretically this exchange rate ought to be written as USD/EUR. However, for each possible currency pair there is one currency that is, buy convention, always quoted as the base. In this instance it is convention that the Euro is used as the base of the pair.
The Major Pairs
Some currencies are exchanged with one another in far larger volumes than others, and for this reason they are known as ‘Major Pairs’. Here are the four major pairs, with the base of the pair shown in bold
EUR/USD . . . Euros / US Dollars
USD/JPY . . . US Dollars / Japanese Yen
GBP/USD . . . Great British Pounds / US Dollars
USD/CHF . . . US Dollars / Swiss Francs
The Commodity Pairs
Although they trade in volumes almost equal to those of the major pairs the following currencies are normally known as the ‘commodity pairs’, because Canada and Australia are principally net exporters of commodities.
The rest of the world frequently exchanges into these two currencies in order to facilitate trade and purchase commodities from these nations. The Canadian Dollar is often referred to as ‘The Funds’ because commodity funds buy into it so heavily, and it is believed to be a leading indicator for certain energy futures markets.
USD/CAD. . . US Dollars/ Canadian Dollars
AUD/USD . . . Australian Dollars / US Dollars
The Minor Pairs
The currencies that form the ‘Minor Pairs’ are less traded than the majors, but many forex traders still choose to include them in their portfolios to bring additional benefits of diversification.
Don’t Get Your Wires Crossed!
It’s worth mentioning at this point that the minor pairs are sometimes referred to as ‘crosses’, and you’ll hear people talking about things like ‘the euro-yen cross’. This simply means the EUR/JPY pair. Crosses are quoted with the major currency as the base of the pair.
There is no clear convention for how the symbol for a pair is written – sometimes a backslash us used between the two (as in EUR/USD) and sometimes not, so you’ll need to check to see how the pairs are written on your broker’s trading platform.
Pegged Exchange Rates
You might be wondering why no pair including the Chinese Yuan has been mentioned – surely this massive country trades outside its own borders and there is an active market for its currency? Indeed there is, and the Yuan has now surpassed the Euro to become the most traded currency in the world after the US Dollar.
To date the Yuan is not traded on the spot market in the way that other currencies are. It’s price is determined, or ‘pegged’, twice daily against other Major pair currencies, in what is known as a ‘price fixing’. These fixings exist to ensure that trade between China and other nations remains easy and predictable. A pegged rate is usually used in order to stabilize the value of a currency by directly fixing its value in a predetermined ratio to a different, more stable or more internationally prevalent currency (or currencies). This is very similar to the way in which the Gold Standard used to be applied to the US Dollar under the Breton Woods system.
So although you are able to purchase Chinese Yuan from your travel agent to take on holiday with you to Beijing, you cannot currently trade Yuan through your broker because all exchange of the currency is controlled by the Chinese government, although this may change one day soon: New Yuan Trading Hub to be Established in Canada.
Exotic Pairs
Any currency pair that is not traded in significant volume generally regarded as ‘exotic’.
Of course, ‘low volume’ is relative (in 2014 the forex market internationally saw about $5.3 trillion change hands every day), and there will always be someone in Armenia wanting to change their Dram into Tala for their holiday in Samoa (AMD/WST), or a company in the UK which needs to purchase Ringgit to import coconut oil from Malaysia (GBP/MYR).
Broker Price Quotations
If you want to trade forex you have a number of options, and understanding exchange rates as quoted by your broker will vary slightly depending on this. Here are some of the different brokerage routes to access the forex market:
Spot Forex
The ‘spot forex market’ refers to cash exchange transactions in the currencies been traded. To trade spot forex you need to use a broker who routes your orders through an ECN to the interbank market, where your money (dollars, say) will literally be changed into another currency within your brokerage account.
Currency Futures
Futures contracts are available for some currencies. Although what you buying is a contract rather than an actual currency, futures prices very accurately track exchange rates in the spot market due to a process known as arbitrage.
The price of currency futures always use the US Dollar as the base, which can be a little bewildering if you’re accustomed to spot prices! The price of the EURO Futures contract @EC is not the same as EUR/USD; it’s the same as USD/EUR. This can actually make things like position sizing (how much of each item in your portfolio to trade) much easier, as everything is in standardized units based on the Dollar.
Have a read here for some more information about the advantages and disadvantages of forex futures.
OTC Derivatives
OTC derivatives are offered ‘over-the-counter’, and include Contracts for Difference (CFDs) and financial Spread Bets. Brokers who facilitate these forms of trading do not submit your orders to the interbank market. Instead, they balance the orders of different traders on their own books, and are known as ‘Dealing Desk’ brokers.
How does this affect the currency prices you see quoted by these types of broker? Rather than charge a commission, such brokers normally make their money from the spread, which is the difference between the price at which you can buy a currency from the broker, and the price at which the broker is willing to buy the currency from you. This is always skewed in the broker’s favor as that is how the broker makes money.
Take a look at the price quote below for EUR/USD . . .
In the interbank market at this time the price for this pair would likely have been 1.2260. If you wanted to buy the pair from a derivatives broker, however, they would sell it to you at 1.2261, and if you wanted to sell the pair they would buy it from you at 1.2259. The broker has asked you to buy at a slightly higher price and to sell at a slightly lower price. The difference between the two prices is ‘the spread’, and it is how the broker makes the equivalent of a commission from your trades.
EXCHANGE RATE NICKNAMESA number of currencies have earned themselves colorful nicknames though history, and these can be useful to know as you’ll often hear them used by market commentators. LOONIE – The Loonie refers to the Canadian Dollar, bills for which feature a picture of the Loonie Bird. CABLE – In the early 1900s price quotes were somewhat delayed, as exchange rate information had to cross the Atlantic! Things speeded up a little with the invention of the telephone, and the GBP/USD cross came to be referred to as ‘Cable’ in reference to the thick steel telecommunications cables that carried signals across the ocean floor. FIBER – On a more modern and humorous note, the EUR/USD pair is often called ‘Fiber’ after the fiber optic cables that now support telecommunication networks! CHUNNEL – The term that is sometimes used to refer to the EUR/USD pair is ‘chunnel’: a portmanteau of ‘Channel Tunnel’, the rail connection between the UK and Mainland Europe. SWISSY – This name is often used to refer to the Swiss Franc, for obvious reasons. Historically, the currency was often viewed as a flight to safety in times of volatility. KIWI – the New Zealand Dollar, and AUSSIE – the Australian Dollar, are also so named for obvious reasons. |