Material-selling and material-buying companies worldwide often encounter a problem: they must purchase materials in one currency but sell them in another, and therefore must fix their foreign exchange (forex) rates with traders at banks. These rates constantly vary as different currencies fluctuate against each other; the idea of currency pairs’ is to identify which two currencies will yield the most favourable rate for trading purposes.
Everyone has different needs regarding purchasing and selling, which means that currency pairs may come into play for both parties. The key is to find the most suitable pairing; often, traders look towards specialising in one currency pair, but professionals may enter several trades every day, which optimises their potential profits.
How Are Currency Pairs Used in Trading?
There are two main types of currency pairs: ‘spot’ and ‘futures’. Spot trading refers to immediate exchanges, where the trader sells one currency in exchange for another at current rates. It might be necessary if a client wants money immediately or does not want to wait until the settlement date (the usual waiting period for futures).
Forex trading involves purchasing one currency now but selling it for another at a future date; this is a widespread practice that allows businesses worldwide to save money on their purchases or make extra profits by buying low now and selling high later. Futures traders tend to keep more complex portfolios than spot traders because they take on additional risks like different time horizons (longer-term futures typically yield higher returns ) and different types of market sentiment.
Which Currency Pairs Are the Most Popular?
It entirely depends on who is trading; some people prefer to specialise in one currency pair, while others believe diversifying their portfolio is more beneficial. Spot traders tend to go for more straightforward pairs like the EUR/USD (euros vs US dollars), as these will always be relatively close in value unless significant events occur. Meanwhile, future traders may choose to buy into USD/CHF (the US dollar against the Swiss franc) or even NZD/JPY (the New Zealand dollar against the yen).
What Factors Do Traders Look Out For?
The idea of a ‘fair’ exchange rate between two currencies can be complicated and subjective. Still, three key factors determine this rate: relative inflation rates, interest rates and the nation’s economic output. Economic output is measured by gross domestic product (GDP), which highlights how much money a country makes per year when its services are factored in with its production capacity.
Traders often identify these three measures when looking for favourable currency pairs to trade. When one currency rises in value against another, it does not necessarily mean that the pair has become more assertive; instead, traders will explore what factors have caused the swing in price. If inflation is higher than usual or GDP growth is meagre, they may avoid buying into that pair because it signifies an unstable market.
Which Currencies Are Weakest?
The most vulnerable currencies are the ones that struggle with inflation problems or poor GDP growth. Traders often point to emerging markets worldwide as being particularly vulnerable to price swings because their economies tend to be less stable and more reliant on outside factors.
Many traders also look towards China’s renminbi for this reason; it is somewhat of a controversial currency due to its controlled economy and fundamental reliance upon foreign trade, which makes it an easy target for exchange rate changes. The Chinese market has been subject to significant disruptions recently, too, and has increased since 2011 before suddenly dropping off last year.
Which Currencies Are Strongest?
In contrast, currencies enjoying higher than average interest rates will grow in value over time due to a ‘carry trade’. It is where traders buy up a particular currency to receive the higher interest rate and then exchange those funds for another currency that yields a lower interest rate.
The Australian dollar was once a favourite target of carrying trades as it possessed high-interest rates compounded by an abundance of natural resources. The euro has been favoured recently because its economy has been growing faster than other major economies. It led to a much higher demand for money in the area.