Forex market currencies are traded in pairs. This is because one currency could be strong against one particular currency but weak against another. It’s all about being relative when trading in the foreign exchange market. Remember that these exchange rate pairs are determined by a huge number of factors, but primarily by a collective belief in the currencies by investors all around the world (including not only large banks and corporations, but us too)!
Let’s take an example of how foreign exchange currencies are paired:
Let’s say that investors feel the US economy is doing relatively well when compared with the UK economy. In the US, the currency is represented as USD (US dollar) and in the UK, the currency is represented as GBP (British pound). Because investors feel the US is doing relatively well when compared with the UK, the USD will gain strength over the GBP. However the GBP, although losing to the USD, could in fact strengthen against another country’s currency simultaneously – so it’s all about being relative and knowing your exchange rates. One currency can look weak in terms of another currency, but strong in terms of another.
Currency pairs usually look like the following: GBPUSD = 1.50
The pair above tells us that it will take 1.5 USD to purchase 1 GBP. So, if the USD gains strength over the GBP, the value of this pair (the exchange rate) might decrease to say 1.4. If you think about it, it is extremely simple! These pairs are always moving and all day too. The increases and decreases in the exchange rate are generally much more gradual than the example given above and a lot more marginal.
All currencies are traded through the interbank market, through the many Forex market makers. The market makers themselves set the quotes based on the pressures of the buying and selling of the currencies that they see when looking at the demand for the currencies vs. other currencies.
Currencies themselves are traded as OTC (Over The Counter) in the spot Forex market. This means that Forex is not traded on a particular exchange around the world but it can be traded anywhere. For e.g. the NYSE (New York Stock Exchange) is traded in a certain physical location, but NASDAQ is not. They are both two different ways in which stocks are traded, but one is OTC, like Forex!
This is just another advantage of trading in foreign exchange market. Market makers have to compete with each other for your business more than for e.g. a stock broker would in the stock market since they work on a physical exchange. This extra competition is healthy and ends up in the favor of the currency traders.
In conclusion, FX currencies are traded in simple pairs that represent the exchange rate and the price of one currency in terms of another. All currencies are traded through the interbank market through market makers and currencies are traded as OTC (Over The Counter). Due to the OTC nature of Forex, there is more competition between the market makers and this is positive for us.