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What Are Currency Pairs

11 Aug 2023

Introduction

Currency Pairs are an important term used in forex trading. Currencies are always traded in pairs, like the INR/USD pair or the EUR/INR pair. A currency pair represents one currency's value against the other; for example, in the case of an INR/USD currency pair, 1 INR will be quoted as 0.012 Dollars. Here, INR in the INR/USD currency pair is the base currency, and USD is the quote currency. If we change the orientation of the notation to the USD/INR pair, then that would mean 1 USD = 82 INR.

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Let's explore the previous example to understand this better:

INR/USD = 0.012

Or, 1/INR/USD = 1/0.012

Or, USD/INR = 82 (~ Approximately)

How do currency pairs work?

A currency pair is quoted as the bid/ask rate by the dealers and brokers in the forex market. To avoid arbitrage, the bid and ask rates have a very minimal spread. The minimal spread that exists is what the broker earns as a commission for facilitating the trade. Let's understand what the bid/ask spread is:

  • Bid Price: The bid price is the price at which the dealer is willing to buy the currency pair.
  • Ask Price: The ask price is the price at which the dealer is willing to sell the currency pair.
  • Bid/Ask Spread: Bid-Ask spread is the difference between the buy price and the sell price.

The Forex market is largely unorganized, and hence, most trades take place on the Over-the-Counter platform. Because there are no centralized exchanges for forex trades, there are certain risks that make it difficult for retail investors to participate in forex trading.

What are the risks involved in currency pairs?

Trading in currency pairs has various inherent risks. Before we dive deep into those risks, let's understand two key terms relating to currency pairs.

  • Currency Depreciation: Currency is said to depreciate when the base currency becomes cheaper w.r.to the quote currency.  
  • Currency Appreciation: Currency is said to appreciate when the base currency becomes more expensive w.r.to the quote currency. 

The three major risks involved in dealing with currency pairs are liquidity risk, political risk, and economic risk. Even though the forex market is the most liquid market that is open 24 hours a day, 5 days a week, there is a certain level of liquidity risk induced either by political turmoil or economic backlash in a country.

Conclusion

Understanding currency pairs is a fundamental aspect of forex trading. To navigate the forex market successfully, traders must have a comprehensive understanding of currency pairs, market dynamics, and risk management. Developing a sound trading strategy and staying informed about global events can help investors make well-informed decisions and seize opportunities while mitigating potential losses.

 

Related Articles: Benefits of Currency Trading in India | 10 Things to keep in mind While exchanging currency

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