Foreign Currency Pairs
Foreign Currencies are traded in pairs, for example Euro/U.S. Dollar (EUR/USD) or U.S. Dollar/Japanese Yen (USD/JPY).
Base vs. Counter Currency. The currency to the left side is called the "base currency" and the one on the right is called the "quote currency" or the "counter currency".
A purchase of a currency pair (e.g., EUR/USD) actually involves 2 separate events. Take the USD/JPY pair. If you "purchase the pair", you are effectively borrowing $100,000 worth of Japanese Yen for every standard contract. If the current exchange rate is 114.15 Japanese Yen for every U.S. dollar, you would be borrowing 11415000 Japanese Yen. Next you convert these Japanese Yen into U.S. dollars at the current exchange rate (114.15 Japanese Yen for ever 1 U.S. Dollar). Now you own $100,000 U.S. dollars and then you lend your U.S. dollars so you can earn interest on them (which can be used to pay any interest owed on the Japanese Yen borrowing). At the beginning of 2006, the interest rate payable on the Japanese Yen was 0.00% and the interest rate payable on the U.S. dollar lending was 4.25%. Hence, the purchaser of this pair will receive positive interest carry of 4.25% (more on rollover interest in Lesson 3).
To help you conceptualize this better, think of yourself at the airport currency exchange booth before going on vacation to a foreign country. If you are a U.S. citizen and you are going to France, you would sell your U.S. dollars and purchase Euros.
Currency pairs that do not involve a person's functional currency (e.g., USD for a U.S. citizen, CAD for a Canadian citizen) are called cross currencies. For a U.S. citizen, the EUR/JPY paid is a cross currency pair.
PIPs. When trading foreign currencies, the term "pip" must be understood. A pip, which stands for "price interest point," represents the smallest fluctuation in the price of a currency. The value of a pip depends on whether a person's functional currency (e.g., USD for a U.S. citizen) is the base currency or the counter currency.
Let's look at a quote example to illustrate the value of a pip. Assume that you receive a bid quote for the EUR/USD pair of 1.1934. Here, 1 Euro equals 1.1934 U.S. Dollars. Most forex dealers offer regular contracts (or lot) sizes of 100,000 units of the base currency. Consequently, 1 lot of 100,000 Euros is worth 119,340 U.S. dollars and a fluctuation of 0.0001 (1 pip) is worth $10 (100,000 x 0.0001). Therefore, every time the price of the euro versus the dollar fluctuates by one pip, the value of each lot changes by 10 dollars. For currencies that are quoted in terms of dollars (that is, when the USD is the counter currency), the PIP value is fixed (10 dollars if the currency is quoted to the fourth decimal place as the EUR/USD is). This is what is called a "static pip value" because the pip value is constant relative to the U.S. dollar.
When the USD is the base currency, the value of a pip will change as the value of the counter currency changes. For example, assume you receive a bid quote for the USD/JPY pair of 114.98. Here, 1 U.S. Dollar equals 114.98 Japanese Yen. Consequently, 1 lot of $100,000 U.S. dollars is worth 11,498,000 Japanese Yen and one pip is worth 1000 Yen (100,000 divided by 0.01). When divided by the exchange rate, a one pip change will represent 8.93 U.S. dollars. This pip value will change as the exchange rate changes. This is what is called a "variable pip value" because the pip value is not constant relative to the dollar.
When trading foreign currencies, you will generally be given a two-sided quote, consisting of a "bid" and an "ask". The "bid" is the price at which you can sell the base currency (at the same time buying the other currency). The "ask" is the price at which you can buy the base currency (at the same time selling the other currency). This type of quote is sometimes referred to as a "choice" quote since you are given the choice of buying or selling at the quoted prices. When figuring your cost of trading, the spread between the bid and ask price is part of that cost. Just multiply that spread by the pip value and you should have a good idea of your trading cost.
Here are a few calculations of trading costs in terms of pip value and corresponding U.S. dollar value.
|Currency Pair||Bid||Ask||PIP Spread||USD Cost per Std Lot|
Before moving on, make sure you understand how these were calculated. To further your understanding, insert some numbers in our Forex PIP Value Calculator and see if it produces the same PIP cost which you calculate on your own.
The process of calculating your profit or loss from a trade uses the same concepts as are used in PIP value calculations, except that you multiply the number of PIPs made or lost on a trade by the PIP value to determine your gain or loss. In addition, you must factor in any rollover interest paid (debited) or received (credited). You can use our Forex P&L Calculator to calculate actual and/or hypothetical gains or losses from trades.
Major vs Minor Currencies. Lastly, no explanation of currency pairs would be complete without a discussion of the distinction between, major, minor and exotic currencies.
At the present time, there are seven currencies which are often viewed as major currencies. These currencies are the U.S. dollar, the Canadian dollar, the British pound, the Swiss franc, the Japanese yen, the Australian dollar and the euro. This varies among with some people excluding the Canadian and Australian dollar from the list.
Although the number of minor currencies fluctuates, they variably include the Swedish kronor and the Danish kroner. These minor currencies generally are in less demand in the spot and
forward markets, have more volatility in value when compared to the major currencies, have an increased likelihood of artificial controls on their exchange rate, and tend to follow a major currency in value fluctuation.
The remaining currencies of the world are referred to as exotics. Most exotics are the currencies of small countries or those which impose controls on currency conversion. The Chinese Yaun pictured to the right is a highly restricted currency which is not generally tradable.
Very few online foreign currency dealers offer trading in minor or exotic currencies.
Demo Trades. Enough on the abstract concepts. Let's enter a trade (not a real one, a demo one) to better illustrate these concepts. If you have not already done so, apply for a demo account with one of the major US online forex trading firms and download their trading software. Once you have done that, go ahead and start the program. The instructions below are based on GFT Forex's. After you start the program, bring up the quote board. If it does not come up automatically, click on View from the upper menu, and then click Quote Board.
Your screen should look something like that above. We are going to purchase on a demo basis the EUR/USD, the most commonly traded pair in the world. Find the pair in the left hand column and then "right-click" on the label. You should see a box similar to that below appear:
Next, left click on New Order and you should see the following appear:
Make sure the order type is Market Order. If it is not, change it to Market Order. Study this screen. You will see that by default, you are purchasing one (1) lot, with a lot size of 100000 base units (or Euros). This contract has as USD size of $121,360 (100,000 EUR * 1.2136). Go ahead and click the Ask(Buy) button and you will have purchase 1 EUR/USD lot. You will then be long the EUR and short the USD and will profit is the value of the EUR increases relative to the USD. This will be reflected in a rising bid price. Note you purchase based on the ask price and sell based on the bid price. This 3 PIP spread is part of the cost of the trade.
There are other ways to enter orders in the platform including clicking on the New Order button in the upper left hand corner. I would refer you to our dealing manuals for complete instructions on how to use the trading platform.