Understanding the Four Major Currency Pairs and How They Work
The forex currency pairs you choose to trade will form a major part of your investment strategy, influencing the broker you choose, the analysis you use, the economies you study and the profits you stand to make.
For the novice investor, a wise course of action is usually to choose one of the four major currency pairs as a way to initiate yourself into the market place. These currencies are the most popular on the forex market, which means that a lot of brokers offer them, and there’s a wealth of available information relating to them.
These pairs are:
- The euro and US dollar
- The US dollar and the Japanese yen
- The British pound and the US dollar
- The US dollar and the Swiss franc.
Read on to find out a little more about them…
The Euro/US Dollar Currency Pair
Trading the EUR/USD pair is commonly referred to as ‘trading the euro.’ The USD acts as the quote currency, whilst the euro is the base currency. The figure stated indicates how many US dollars are required to purchase a single euro. Thus, if the pair is trading at 1.50, this means that 1.5 USD are required to buy 1 euro.
The value of these currencies compared to each other is strongly influenced by the interest rate differential between the European Central Bank and the Federal Reserve (Fed). As a result, the value of the EUR/USD cross will often weaken when the Fed acts in the open market to make the USD stronger.
There is often a negative correlation between this currency pair and the USD/CHF pairing. However, it shares a strong correlation with the GBP/USD pair, as there is a positive relationship between the euro and the British pound.
The US Dollar/Japanese Yen Pair
Trading the USD/JPY is commonly termed ‘trading the gopher’. The yen acts as the quote currency, indicating how many JPY are required to purchase a dollar. If, for example, the pair is trading at 1.50, this means that 1.5 yen would be needed to purchase 1 dollar.
One of the main influences on the relationship between the two currencies is the interest rate differential between the Fed and the Bank of Japan. Because the yen is the quote currency, this means that open market activity by the Fed to strengthen the US dollar makes the value of the cross increase, unlike the EUR/USD pair.
As a rule, this currency combination positively correlates with the USD/CHF and USD/CAD currency pairs as they share the US dollar base currency in common.
The British Pound/US Dollar Pair
Trading the GBP/USD currency pair is usually referred to as ‘trading the cable’. The dollar acts as the quote currency, whilst the pound is the base currency. This means that if the pair were trading at 1.50, you would need to spend 1.5 dollars to buy 1 pound.
One of the greatest influences on the relationship between the two currencies is the interest rate differential between the Bank of England and the Fed. If we once again imagine that the Fed intervenes in open market activities to strengthen the dollar, this would cause the value of the pairing to decline.
The GBP/USD combination shares a strong correlation with the EUR/USD currency pair because of the correlation between the euro and the pound. It usually negatively correlates with the USD/CHF combination.
The US Dollar/Swiss Franc Pair
The fourth and final pair is the US dollar/Swiss franc combination, whose investors are commonly described as ‘trading the Swissie’. The franc acts as the quote currency, meaning that a figure of 1.50 would translate as needing 1.5 Swiss francs to purchase 1 dollar.
The largest influence on the relationship between this pairing is the interest rate differential between the Fed and the Swiss National Bank. This means that if the US dollar grows stronger, the value of the franc increases.
The EUR/USD and GBP/USD pairings both share a negative correlation with this combination, as there is a positive correlation between the Swiss franc and the pound and euro.
The popularity of this currency is one of the main reasons that the chaos caused by the recent Swiss crisis has proved widespread. The event, which saw Switzerland remove its currency cap, has made the franc increasingly volatile, which means that it may no longer be suitable as a choice for the inexperienced.
Which currency pair or pairs will you choose to trade?
