What is a Currency Pair and What are Their Types?

• What is a Currency Pair?
• Understanding a Currency Pair
• Types of Currency Pairs

What is a Currency Pair?

A currency pair shows the value of one currency compared to another. The first currency is called the base currency, and the second is the quote currency. It tells you how much of the quote currency is needed to buy one unit of the base currency. For instance, a currency pair like EUR/USD shows the euro’s value compared to the US dollar. In this pair, EUR is the base currency, and USD is the quote currency. It indicates how many US dollars are needed to buy one euro. Currencies are identified using three-letter codes: EUR for the euro, USD for the U.S. dollar, CAD for the Canadian dollar, and AUD for the Australian dollar. 

Let’s break it down simply with an example using the EUR/USD currency pair:

If the EUR/USD exchange rate is 1.05928, it means 1 euro is worth 1.05928 U.S. dollars.

• Buying EUR/USD means you are buying euros and selling U.S. dollars.
• Selling EUR/USD means you are selling euros and buying U.S. dollars.

In forex trading, every trade involves two currencies at the same time, when you buy one, you automatically sell the other. This is because currencies are always traded in pairs, like EUR/USD.

Figure 1: EUR/USD Currency Pair Example

How Does a Currency Pair Work? 

Using the same example of EUR/USD (Figure 1), let’s consider a scenario where the euro strengthens against the U.S. dollar. This could happen for instance when the European Central Bank (ECB) raises interest rates, one of the causes that could increase the value of a currency. Higher interest rates often attract more investors seeking better returns, increasing demand for the euro and making it more valuable (appreciated) compared to the dollar. As a result, one euro will be worth more dollars, causing the pair’s price to increase.

For example:

• Before the euro appreciates, the price is EUR/USD = 1.05928.
• After the euro appreciates, the price rises to EUR/USD = 1.07840.

This reflects the stronger euro being able to buy more US dollars.

On the other hand, if the euro loses value (depreciates) against the U.S. dollar, the pair’s price is likely to decline, potentially driven by weak economic data. Let’s explore a scenario where the euro weakens against the U.S. dollar. This could happen if the European Central Bank (ECB) lowers interest rates. Lower interest rates make the euro less attractive to investors seeking higher returns, reducing demand for the currency and decreasing its value compared to the dollar. As a result, one euro will be worth fewer dollars, causing the pair’s price to drop.

For example:

• Before the euro depreciates, the price is EUR/USD = 1.07840.
• After the euro depreciates, the price falls to EUR/USD = 1.05928.

This reflects the weaker euro being able to buy fewer US dollars.

If you believe the base currency will get stronger compared to the quote currency, you can buy the pair. If you think it will weaken, you can sell the pair.

Types of Currency Pairs

Currency pairs are categorized into three main types: Majors, Crosses, and Exotics. Let’s take a closer look at each category:

Major Currency Pairs

The major currency pairs are the most popular and widely traded in the forex market. There are 8 major currencies because these are the most widely traded and important currencies in the global economy, such as the USD, EUR, JPY, GBP, AUD, CAD, CHF, and NZD. However, there are only 7 major currency pairs because a major pair is defined as a currency pair that always includes the U.S. dollar (USD) on one side. 

Here’s the list of the 7 major currency pairs:

• EUR/USD
• USD/JPY
• GBP/USD
• AUD/USD
• USD/CHF
• USD/CAD
• NZD/USD

Major pairs tend to have more frequent price movements compared to other types of pairs, like crosses and exotics. This means they provide more trading opportunities and are easier to trade because they are the most liquid.

What does liquidity mean?
Liquidity refers to how actively a currency pair is bought and sold in the market. The more people trading a pair and the higher the trading volumes, the more liquid it is.

For example:

• The EUR/USD pair (euro and U.S. dollar) is traded by many people in large amounts, so it is very liquid.
• The AUD/USD pair (Australian dollar and U.S. dollar) is traded less frequently and in smaller amounts, so it is less liquid.

Why Trade Major Pairs?

Major pairs offer high liquidity, which makes it easy to enter and exit trades quickly. They are supported by abundant news and analysis, keeping traders well-informed. Additionally, they tend to be less volatile than exotic or cross-pairs, making them more predictable and beginner-friendly.

Crosses Currency Pairs

Currency pairs that include two major currencies but exclude the U.S. dollar (USD) are called cross-currency pairs or simply crosses. These pairs let traders exchange one major currency for another without involving the U.S. dollar.

Crosses that are popular and actively traded are often referred to as minors. While not as heavily traded as major pairs, crosses still offer good liquidity and trading opportunities, especially for those looking to trade between specific regions or economic zones.

For Example:

• EUR/GBP (euro and British pound), this pair is popular for trading between European countries and the UK.
• AUD/JPY (Australian dollar and Japanese yen), a common pair for traders looking to focus on the Asia-Pacific region.

Why Trade Crosses?
Cross-currency pairs can be appealing because they allow traders to focus on specific economies or regions without the influence of the US dollar. For example, if you believe the Australian dollar will strengthen compared to the Japanese yen, you can trade AUD/JPY directly instead of involving USD. This can help reduce the impact of US-based economic factors.

Exotic Currency Pairs

Exotic currency pairs are not something flashy or unusual, despite the name. They are currency pairs that include one major currency (like the U.S. Dollar or Euro) paired with the currency of a developing or emerging economy. For example:

• USD/BRL: U.S. Dollar and Brazilian Real
• EUR/TRY: Euro and Turkish Lira
• USD/MXN: U.S. Dollar and Mexican Peso

These pairs are called "exotics" because the currencies from emerging markets aren’t traded as much as the majors (like EUR/USD or USD/JPY). Because fewer people trade them, it can be harder to buy or sell quickly. They’re also very sensitive to political and economic events, things like elections or scandals can cause their value to change dramatically. 

For Example:

Imagine you’re trading USD/TRY (US Dollar and Turkish Lira). If unexpected election results come out in Turkey, the value of the Lira might drop or rise sharply, creating big swings in the pair’s exchange rate.

Why Trade Exotic Pairs?

Exotic pairs can be appealing because they often have bigger price swings, offering profit opportunities. They also provide access to fast-growing emerging markets and unique trading opportunities. With less competition, traders may find more chances to spot trends. However, they come with higher costs and risks, making them better suited for experienced traders.

Conclusion

In conclusion, understanding currency pairs is essential for navigating the forex market. Whether trading major pairs with their high liquidity and stability, crosses that eliminate the need for USD, or exotic pairs with unique opportunities and risks, knowing the characteristics of each type can help traders make informed decisions. By grasping how currency pairs work and the differences between these categories, traders can better align their strategies with their goals and risk tolerance.