Find out what currency pairs are, how they work and how you can use them to build wealth.
If you’ve ever watched or read a report on the global financial markets, you will have noticed that the value of currencies is always quoted in pairs. For example, 1 AUD = X amount of USD, or 1 EUR = X amount of USD. These are called currency pairs and they allow you to determine the value of one currency relative to another on the global foreign exchange market.
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What is a currency pair?
Currencies on the foreign exchange market are always traded in pairs - you always buy or sell one currency against another. For example, you might use your Australian Dollars to buy some US Dollars, or your US Dollars to buy British Pounds. A currency pair therefore allows you to see the value of one currency as compared to another.
The first currency quoted in a pair is called the base currency, the second is called the quote currency.Back to top
How does a currency pair work?
The value of a currency pair will rise and fall based on a wide range of factors. Look back at a graph of the performance of the Australian Dollar relative to the US Dollar over the past 10 years and you’ll see fluctuations up and down that have been caused by a variety of factors.
The appreciation or depreciation in value of one currency will affect the other. For example, when the USA was hit by the subprime mortgage crisis in 2008, the value of the US Dollar dropped substantially relative to most of the world’s major currencies.
The laws of supply and demand will also cause a currency’s value to rise and fall. If the outlook looks positive for a country’s economy, there may be high demand on global forex markets for its currency. This could drive the currency’s value up relative to other currencies.
If a country has too many imports relative to the amount of goods and services it exports, this can lead to an imbalance of trade and prompt a drop in the value of a currency. And because the value of a currency is one of the biggest indicators of the performance of a nation’s economy, it can even have an impact on a country’s Gross Domestic Product (GDP) and cash rate.
For example, if the value of the Australian Dollar decreases compared to other major currencies, you would expect to see an increase in exports and therefore in GDP as Australian-made products become cheaper overseas. The stability of the Dollar is also one of the key factors the RBA considers when deciding whether to raise, cut or not touch the official cash rate - for example, raising the cash rate can lead to an increase in the value of the Dollar as investors turn to Australia for high yield.Back to top
What are the most popular currency pairs?
The US Dollar is the most commonly traded currency in the world - in April 2013, it made up more than 87 per cent of the daily share on global foreign exchange markets. It is followed by the Euro, the Japanese Yen, the Pound Sterling, the Australian Dollar and the Swiss Franc.
Below is a list of the most popular currency pairs:
How do I know when is the right time to exchange my currency pair?
You’ll need to take a number of factors into account in order to determine when is the right time to buy or sell a particular currency. In terms of the AUD/USD currency pair, you could examine the official cash rate and any predicted changes from the Reserve Bank, inflation figures and the overall level of consumer confidence. Another factor to consider is the much talked about housing bubble in Australia - if that bubble were to burst and property prices plummeted, the Australian Dollar would drop and may not represent good value for investors.
As mentioned above, supply and demand for exports and imports can play a huge part in determining how a currency will perform now and into the future. Similarly, economic crises can lead to a significant downturn in a country’s economy and therefore the value of its currency. For example, the Global Financial Crisis of 2008 spread across the Eurozone, prompting the value of the Euro to drop against most major currencies.
You therefore need to examine a range of factors to formulate an idea about whether the value of a currency is expected to rise or fall in the future, and then trade accordingly.Back to top
What are things to avoid about currency pairs?
The main issue associated with trading currency pairs is that it is a complex investment method. As this article shows, there are many factors that can affect the performance of a currency, so predicting whether its value will rise or fall in the future is a risky business. You need to make sure you’re fully aware of all the risks involved in trading currency pairs before you part with any of money.