Base Currency – Forex Explained
Currencies in the Forex market are always quoted in pairs: base and quote currency. The quote currency is also known as the counter currency.
The base currency plays a vital role in foreign exchange rates and transactions. Moreover, it determines the rise and fall of currency pair prices on Forex. Thus, it directly impacts gains and losses and buying and selling. Its buying price and its selling price also determine the spread.
For inexperienced traders, this terminology may be confusing. However, it’s very important to understand what it is in a Forex quote and its importance in Forex transactions.
Also, many trading platforms help you to understand better, or you can find a forex broker for more information.
Currency pair: the foundation of the foreign exchange market
The quotation and price structure of currencies traded in the Forex are organized in pairs: the value of one currency is assessed against another.
Currency pair: the ratio between quoted currency and the quoted currency
The first of the two currencies in a pair is called the “quote currency,” and the second “quoted currency.” The parity specifies how much-quoted currency it takes to buy one unit of the quoted currency.
Currency pair: a unit that is bought and sold like a security
All forex trading involves buying one currency at the same time as selling another. Still, the currency pair can be considered a single unit, like a security bought or sold.
If you buy a currency pair, you buy the quote currency and sell the quote currency. The bid (purchase price) represents the sum necessary in quoted currency to be disbursed to acquire a unit of the quoted currency.
Conversely, when you sell the pair, you sell the quote currency and receive the quote currency in exchange. The ask (selling price) of the currency pair expresses the sum you can recover, in quoted currency, thanks to the sale of a unit of the quoted currency.
Buying and selling a currency pair: example
For example, if the USD/EUR currency pair is quoted as EUR/USD = 1.50 and you buy the pair, it means that for every 1.5 dollars sold, you receive 1 euro. If you sell the currency pair, you will receive $1.5 for each euro. The opposite of the course of these currencies is USD/EUR. The corresponding price would be USD/EUR = 1 / 1.50 = 0.667. This means that 0.667 euros are equivalent to buying 1 dollar.
What is base currency?
As we already mentioned, Forex quotes are always made up of two currencies. The base appears to be the first of the pair. For example, in the USD/JPY quote, USD is the first currency mentioned; thus, it represents the base currency.
The abbreviations for currencies are determined by the International Organization for Standardization – ISO. The codes for forex market currencies are specified in standard ISO 4217. Foreign exchange markets use these three-letter codes to represent a specific currency. Currencies that make part of the currency pair are separated with a slash.
The currency purchased or sold in relation to another, known as the quote currency, is the base currency. It always has a value of 1.
Consider that you are considering the USD/JPY pair. A quote of 125.3 indicates that 1 USD is equivalent to 125.3 Japanese Yen.
Due to its stability and status as the quintessential commercial currency, the US dollar is generally quoted as the base currency. Consequently, there are USD/JPY, USD/CAD, USD/CHF, etc. Alternatively, it will be indicated in the EUR/USD, GBP/USD, and AUD/USD pairs as the counter currency.
Whether the base currency is the US dollar or another currency, it plays a vital role in Forex transactions.
The role in Forex transactions
The base currency is essential in Forex transactions. Actually, for currency-buying transactions, it is the purchased currency. In a sell transaction, the base currency is sold.
The quote is up when the base increases while the quoted currency depreciates. On the other hand, a decline in the price quoted means that the base currency has lost its value. Therefore, it influences Forex’s gains and losses in one way or another.
As a Forex trader, you can take a long or short position.
Opening a long position means you expect the base currency to rise or the quote currency to fall.
If you go for a short position, you expect the base currency to fall against the quote currency. For instance, if you expect the USD to fall in value or the euro’s value will rise, you will buy EUR/USD.
The real challenge in Forex is to anticipate and predict trends in currency prices. Here again, the first part of a currency pair is a decisive factor. Being able to anticipate the evolution of currency pairs is undoubtedly the key to success in Forex. Therefore, the trader must make an informed choice of the currency pair he wants to speculate on.
Then, using analysis tools, the Forex trader can forecast the price trends. Good anticipation of the evolution of the base currency is practically a guarantee of gain. On the other hand, a wrong forecast can be disastrous and lead to losses. If you are a newbie trader, it’s not advisable to speculate on exotic currencies because of their instability, making their price fluctuation difficult to predict.
Influence on spread
The base currency is also important for determining the spread. In Forex, the spread is the difference between the buy price and its sell price.
For example, if the EUR/USD pair is quoted at 1.4035/1.4039, the euro’s buy price is 1.4035, and its sell price 1.4039. The spread will therefore be equal to 1.4039-1.4035 or 4 pips. The PIP represents the broker’s commission.
All in all, the base currency has a definite influence on the gains and losses of traders. It is of capital importance in Forex trade because it determines the rise or fall of prices.
We never give the quotation of a single currency, such as: what is the rate of the dollar or what is the rate of the yen? This only makes sense when comparing one currency with another. In this case, the currencies are quoted in pairs. Thus we will speak of the quotation of the euro against the dollar (EUR/USD) or the pound sterling against the yen (GBP/JPY), for example. International codes are always used to name currencies in Forex.
It should also be noted that the currencies being small quantities and their variations being small, their quotation is displayed to four decimal places. Example of a quote for the euro/dollar pair: 1.2055.
In the language of forex traders (the name given to investors in the foreign exchange market), the smallest level of quotation is called a “pip.” Thus, when the euro/dollar goes from 1.2040 to 1.2043, we say that the variation is three pips.
Example of a transaction:
Let’s assume a price of 1.2000 for the euro/dollar pair. If the investor thinks that the price of this pair will rise, he will buy the euro/dollar, which breaks down as follows: he buys euros and sells dollars.
This operation is, however, completely transparent for the user since he plays directly on the pair.
Example of transaction fees
Consider the following quotation on the euro/dollar:
Buy: 1.2052 / Sell: 1.2050
That means that at this time, you can buy EUR/USD at 1.2052 and sell it at 1.2050. The difference of 2 pips between buying and selling is the spread. It is the broker’s commission. In this example, the transaction costs are, therefore, 0.0002 / 1.2050 = 0.017%, or at least ten times lower than the transaction costs for acquiring market shares.
In light of this example, it is easy to understand the attraction of this market for “day traders” who can thus make many round trips without being penalized by the marginal transaction costs.
Most popular base currencies in Forex
The most popular, or major currencies, refer to the most traded currencies, such as the US dollar, Japanese Yen, the euro, and the Swiss franc. The USD is the most important currency in Forex.
It is a reference currency, given its stability. This stability is explained in particular by the rigorous policy of the American Federal Reserve, the solidity of legal institutions, and also by significant foreign investments.
Interest in this currency is reinforced by the issuance of bonds and financial securities by the US Treasury. 80% of transactions involve the US dollar. But, the dollar is challenged by the euro on the currency market.
The euro is particularly valued in Forex thanks to the actions of eurozone countries, including Germany and France. However, this currency is penalized by a European economy plagued by frequent crises, a high unemployment rate, a weak growth rate, and poor budgetary management.
This situation of instability limits the confidence of potential investors and relegates this currency to second place after the US dollar. The classification of the Japanese yen as a primary currency is explained by the importance of the Japanese economy on a global level.
The demand for the yen is rather limited, but the repatriation of currencies carried out by large Japanese companies is significant. The Swiss franc is a safe haven due to the strength of the Swiss banking system and the stability of the Swiss economy.
