The Base Currency
One currency in a currency pair is always dominant, “only in the way it is quoted”. It is called the Base Currency. The base currency is identified as the first currency in a currency pair. It also is the currency that remains constant when determining a currency pair's price.
The Euro is the dominant base currency against all other global currencies. As a result, currency pairs against the EUR will be identified as EUR/USD, EUR/GBP, EUR/CHF, EUR/JPY, EUR/CAD, etc. All have the EUR acronym as the first in the sequence.
The British Pound is next in the hierarchy of currency name domination.
The major currency pairs versus the GBP would, therefore be identified as GBP/USD, GBP/CHF, GBP/JPY, GBP/CAD. Apart from the EUR/GBP, expect to see GBP as the first currency in a currency pair.
The USD is the next dominant base currency. USD/CAD, USD/JPY, USD/CHF would be the normal currency pair convention for the major currencies. Since the EUR and the GBP are more dominant in terms of base currencies, the dollar is quoted as EUR/USD and GBP/USD.
Knowing the base currency is important as it determines the values of currencies “notional or real” exchanged when a foreign exchange deal is transacted.
The Counter Currency
The Counter Currency is the second currency in a Currency Pair notation.
For example, the JPY is the Counter Currency in the USD/JPY pair. The USD becomes the counter currency in the EUR/USD pair.
The Value of Currencies
The base currency is always equal to one of the currency's monetary unit of exchange i.e., 1 Euro, 1 Pound, 1 Dollar etc.
When a trader buys 100,000 EUR/USD, he is said to be buying or receiving the EURO or the Base Currency and selling or paying for the USD or Counter Currency. The amount of the Base Currency he is buying is equal to 100,000 Euros.
Note that this is true no matter the current exchange rate at the time. The base currency amount remains constant.
The Counter Currency equivalent amount that the investor is selling (or paying), on the other hand, will fluctuate with the exchange rate for the Currency Pair.
It is equal to:
(Amount of Base Currency x Market Foreign Exchange Rate)
Since the Counter Currency is the part of the currency pair that fluctuates higher or lower, it indicates the relative strength or weakness of both currencies in a currency pair. As one currency goes up, the other must go down in relation to one another.
Question 1:
Given a Foreign Exchange rate for the EUR/USD Currency Pair of 1.2049, a trader who buys (or receives) 100,000 Euros would be selling (or paying) what equivalent amount of US dollars?
Question 2:
If a trader buys the EUR/USD at 1.2051 because he has identified a trading opportunity, and the value of the EUR/USD Currency Pair goes to 1.2095, did the trader make a profit or loss on the trade?
Question 1 - Answer:
Base Currency Amount = 100,000 Euros Foreign Exchange Rate = 1.2049
100,000 x 1.2049 = $120,490.00
The trader would be buying or receiving, 100,000 Euros and selling or paying, 120,490 US Dollars.
The forex trader made a profit.
By buying the EUR/USD at 1.2051, the trader bought or received 100,000 Euros and sold or paid US$120,510. When the exchange rate rose to 1.2095, the trader could now sell the 100,000 Euros for US$120,950.
Since the trader initially paid or sold $120,510 for the Euros, the total profit on the transaction is equal to $120,950 (the amount now received or bought from selling the Euros at 1.2095) minus $120,510 (the price originally paid or sold).
Total Profit = $440
