A currency pair's base currency is the primary currency. Base currencies indicate the amount required to buy one unit of the second or quoted currency in a currency pair. People widely use the U.S. dollar as a base currency. In this article, we look at understanding the concept of base currency in forex trading. Explore its definition, and how it functions in currency pairs.
What Is Base Currency in Forex Trading?
A currency pair's base currency is the first listed currency. In the foreign exchange market, currency pairs represent the quotation of currency unit prices. In currency pairs, the base currency is typically the domestic currency, while the quote currency or counter currency comes next.
Currency pairs in the forex market typically display as XXX/YYY, where XXX signifies the base currency. Understanding the relationship between the base currency and the quoted currency is essential to grasping the concept of currency exchange rates.
Currency pairs show the amount of quoted currency required to purchase one unit of the base currency at a given exchange rate. For example, when you see EUR/USD = 1.55, it indicates that €1 is equivalent to $1.55.
Based on current foreign exchange rates, if a trader wishes to buy €1, they would need to pay $1.55. The same method applies to reading the currency pair quotation when selling the base currency. For example, if someone wants to sell €1, they will receive $1.55 for it.
Understanding Base Currencies
Currency exchange takes place on the foreign exchange, or forex, market (FX). Trillions of dollars’ trade on it daily, making it one of the most liquid markets globally.
Trades use currency pairs, which comprise a base currency and a quote or counter currency. Typically, we write pairs in the format XXX/YYY or XXXYYY, where XXX stands for the base currency and YYY for the quote currency. Here are some examples: GBP/AUD, EUR/USD, USD/JPY, GBPJPY, EURNZD, and EURCHF.
Currency codes typically denote currencies. The International Organization for Standardization (ISO) assigns specific abbreviations to currencies. The standard ISO 4217 format provides these codes. Three-letter codes represent currency pairs and correspond to specific currencies.
Currency pairs commonly use USD for the U.S. dollar, EUR for the euro, JPY for the Japanese yen, GBP for the British pound, AUD for the Australian dollar, CAD for the Canadian dollar, and CHF for the Swiss franc. The forex market widely uses the U.S. dollar, also known as USD, as a base currency.
Traders use the base currency to calculate the amount of quote currency required to buy one unit of the base currency. Let's take a look at the CAD/USD currency pair, as an expert in finance. In this case, the Canadian dollar serves as the base currency, while the U.S. dollar acts as the quote currency.
How Base Currency Works
When it comes to forex trading, understanding the exchange rate is crucial. The exchange rate shows how many units of the quoted currency can be purchased with one unit of the base currency. Consider this scenario: When the USD/EUR exchange rate stands at 1.20, it signifies that a single US dollar has the purchasing power of 1.20 euros.
We always set the base currency to one unit and then determine the value of the quoted currency in relation to the base. The following example will illustrate this: When the USD/EUR exchange rate is 1.20, it signifies that one euro holds a value of 1.20 US dollars.
When a trader purchases a currency pair, they acquire the base currency while simultaneously selling the quoted currency. For example, when a trader decides to purchase the USD/EUR currency pair, they are essentially acquiring US dollars while simultaneously selling euros. If the exchange rate between the two currencies goes up, the trader can sell the currency pair and make a profit.
On the other hand, when a trader decides to sell a currency pair, they are actually selling the base currency and purchasing the quote currency. It is important to note that when a trader decides to sell the USD/EUR currency pair, they are essentially selling US dollars and purchasing euros. When the exchange rate between the two currencies drops, traders have the opportunity to purchase the currency pair at a reduced price, allowing them to potentially earn a profit.
Why is Base Currency important?
Understanding the base currency is critical in forex trading, as it plays a significant role in determining the value of the quoted currency and ultimately impacts a trade's profitability. For instance, if a trader purchases the USD/EUR currency pair, they are speculating that the US dollar will appreciate in value compared to the euro. If the exchange rate between the two currencies goes up, the trader can sell the currency pair and make a profit.
On the other hand, when a trader decides to sell the USD/EUR currency pair, they are expressing their belief that the euro will gain strength in comparison to the US dollar. If the exchange rate between the two currencies decreases, the trader has the opportunity to purchase the currency pair at a reduced price, resulting in a potential profit.
The base currency is crucial when it comes to calculating profit and loss in forex trading. To realize their gains or losses, traders must convert their profits or losses back into their account currency. This involves calculating the profit or loss in the base currency and then converting it accordingly.
Investors express forex quotations as pairs because they engage in simultaneous buying and selling of currencies. When a buyer makes a purchase of EUR or USD, it signifies their acquisition of euros while simultaneously selling U.S. dollars. When the base currency (EUR) is at a higher value, it requires a greater amount to purchase a single unit of the quoted currency (USD).
It is important to note that the trader would need to allocate a greater amount of euros in order to purchase a single US dollar.
Investors typically purchase the pair when they believe that the base currency will appreciate compared to the quoted currency. Alternatively, they might choose to sell the pair if they anticipate a depreciation of the base currency relative to the quote currency.
Pros and cons of base currencies
Pros
You have better control over your trade, since you’re trading with your own currency
You can take advantage of local market knowledge, since you’re familiar with the economic and political factors that impact your own currency
You can easily calculate your profits and losses, since your account currency is the same as the base currency
You may be exposed to lower risks, since fluctuations in your own currency may not impact the value of your trades
Cons
You may face higher transaction costs, since you’ll need to convert your currency to the counter currency in order to trade.
You may be exposed to higher risks, since fluctuations in your own currency can impact the value of your trades
You may miss out on some trading opportunities, since some currency pairs may not be available in your base currency
You may have less control over your trade, since you’re trading with a foreign currency
You may need to calculate your profits and losses in a foreign currency, which can be more complicated
Conclusion
Understanding the base currency in a currency pair is essential for grasping exchange rates and profitability in forex trading. As traders engage in currency trading, they strategically buy and sell currency pairs to capitalize on fluctuations in exchange rates. The base currency determines the value of the quoted currency, thereby influencing the profitability of each trade. Having a solid grasp of the base currency is crucial for any forex trader aiming to thrive in the global currency markets.
The foreign exchange market is where traders purchase and sell currencies. There is no central marketplace available around the clock every day of the week. However, gaining a grasp of certain intricacies is crucial if you want to make a profit from currency trading.
Typically, we sell these assets in pairs, like the USD/GBP, the USD/CAD, and the USD/CHF. In these cases, the USD serves as the base currency, while the others are known as the quote currencies. When deciding on a base currency, it's important to take into account the economy of the home country and the level of trading activity. That is, of course, if you haven't already decided on a specific currency.
