Why Do Currencies Trade In Pairs
Tuesday, 2 November 2010
This is a concept that many newbie's find confusing at first, but it’s actually very simple. Whenever you enter a currency trade, there are two currencies involved. Think about the traveler from our earlier discussion, who exchanged his homeland’s currency for the currency of the land he was visiting. You’ll recall that there were two currencies involved in the transaction, but only one exchange rate.
Every foreign exchange transaction, or forex trade, involves two currencies and one exchange rate. The best way to illustrate the reason for this is to attempt to initiate a currency transaction that involves just one currency.
For example, if you live in the United States, walk down to your local grocery store and ask the person behind the counter, “How many U.S. Dollars will you give me in exchange for 20 U.S. Dollars?
After the clerk gives you a sideways look, he’ll assume that you want change for a twenty, and $20 is exactly what you’ll get—no more and no less. Nobody is going to offer you more than $20 for a $20 bill, so you cannot profit from this exchange.
Imagine the difficulty involved in trying to trade just one currency. Will any sane person offer more than one British pound in exchange for another British pound? Remember, we are not speaking about collectible coins or interest-bearing loans, just a pure currency exchange.
Conversely, a clever trader might offer less than one British pound in exchange for one British pound, but only a fool would accept this proposition. This explains why we cannot trade just one currency at a time. This is because the value of a currency itself does not change, but its value can change in relation to another currency. In other words, that dollar in your pocket will still be worth $1 tomorrow; however, its value constantly fluctuates relative to other currencies. This is why we must trade currencies in pairs.
In the years that followed, the exchange rate changed dramatically, and by 2006 it had fallen to 1.10. This meant that a traveler from the United States to Canada in 2006 would only receive about C$1.10 in Canadian currency for every U.S. Dollar exchanged.
If we wanted to measure very small changes in this exchange rate, it could be expressed as 1.1000. We can safely say that the U.S. Dollar depreciated significantly against the Canadian Dollar during the early part of the twenty-first century.
How does this affect our traveler? As the U.S. Dollar/Canadian Dollar exchange rate fell, U.S. Dollars bought fewer Canadian goods and services.
A U.S. citizen landing in Toronto used to enjoy receiving a thick wad of cash from the airport’s currency exchange kiosk. Visitors from the United States would spend freely, because goods and services seemed inexpensive compared to the prices at home.
As the Canadian Dollar gained strength against the U.S. Dollar, all of this changed. Eventually, the Canadian Dollar approached parity to the U.S. Dollar. While this had a negative impact on visitors from the United States, Canadian travelers were pleased to find that U.S. goods and services were now relatively cheap. As the U.S. Dollar weakened, the comparative buying power of the Canadian Dollar grew.
U.S. citizens were now less likely to visit Canada. If they did, they were likely to spend less than they would have in the past, when the exchange rate was more favorable. Canadian travelers, however, were more likely to visit the United States, since the Canadian currency bought more U.S. goods and services than it had previously.
This resulted in a huge influx of shoppers from Europe visiting the United States, especially around the Christmas holiday season. One European trader explained to me that it was less expensive for him to fly to New York City, stay in a hotel, shop, and return home than it would be to simply stay at home and shop.
While there can be no doubt that fortunes were made and lost on the huge movements described above, we will see how even a tiny move in exchange rates can result in substantial gains or losses. This is how forex traders make money.
Every foreign exchange transaction, or forex trade, involves two currencies and one exchange rate. The best way to illustrate the reason for this is to attempt to initiate a currency transaction that involves just one currency.
For example, if you live in the United States, walk down to your local grocery store and ask the person behind the counter, “How many U.S. Dollars will you give me in exchange for 20 U.S. Dollars?
After the clerk gives you a sideways look, he’ll assume that you want change for a twenty, and $20 is exactly what you’ll get—no more and no less. Nobody is going to offer you more than $20 for a $20 bill, so you cannot profit from this exchange.
Imagine the difficulty involved in trying to trade just one currency. Will any sane person offer more than one British pound in exchange for another British pound? Remember, we are not speaking about collectible coins or interest-bearing loans, just a pure currency exchange.
Conversely, a clever trader might offer less than one British pound in exchange for one British pound, but only a fool would accept this proposition. This explains why we cannot trade just one currency at a time. This is because the value of a currency itself does not change, but its value can change in relation to another currency. In other words, that dollar in your pocket will still be worth $1 tomorrow; however, its value constantly fluctuates relative to other currencies. This is why we must trade currencies in pairs.
The Canadian Dollar and The U.S. Dollar
In 2002, our traveler would have received about C$1.60 in Canadian currency for every U.S. Dollar. We could say that the exchange rate at that time for the U.S. Dollar/Canadian Dollar was about 1.60 Canadian Dollars per U.S. Dollar. If we wanted to be precise, we could add several decimal spaces, and express the exchange rate as 1.6000.In the years that followed, the exchange rate changed dramatically, and by 2006 it had fallen to 1.10. This meant that a traveler from the United States to Canada in 2006 would only receive about C$1.10 in Canadian currency for every U.S. Dollar exchanged.
If we wanted to measure very small changes in this exchange rate, it could be expressed as 1.1000. We can safely say that the U.S. Dollar depreciated significantly against the Canadian Dollar during the early part of the twenty-first century.
How does this affect our traveler? As the U.S. Dollar/Canadian Dollar exchange rate fell, U.S. Dollars bought fewer Canadian goods and services.
A U.S. citizen landing in Toronto used to enjoy receiving a thick wad of cash from the airport’s currency exchange kiosk. Visitors from the United States would spend freely, because goods and services seemed inexpensive compared to the prices at home.
As the Canadian Dollar gained strength against the U.S. Dollar, all of this changed. Eventually, the Canadian Dollar approached parity to the U.S. Dollar. While this had a negative impact on visitors from the United States, Canadian travelers were pleased to find that U.S. goods and services were now relatively cheap. As the U.S. Dollar weakened, the comparative buying power of the Canadian Dollar grew.
U.S. citizens were now less likely to visit Canada. If they did, they were likely to spend less than they would have in the past, when the exchange rate was more favorable. Canadian travelers, however, were more likely to visit the United States, since the Canadian currency bought more U.S. goods and services than it had previously.
The Euro and The U.S. Dollar
The rise of the euro created a similar situation. The euro made dramatic gains against the U.S. Dollar in 2002, 2003, and 2004, and during that time the value of the euro rose from about US$0.8500 cents to above US$1.3500. Due to this shift in exchange rates, U.S. citizens found that vacationing in Europe became much more expensive, while persons visiting the United States from Europe found that their buying power had increased dramatically.This resulted in a huge influx of shoppers from Europe visiting the United States, especially around the Christmas holiday season. One European trader explained to me that it was less expensive for him to fly to New York City, stay in a hotel, shop, and return home than it would be to simply stay at home and shop.
While there can be no doubt that fortunes were made and lost on the huge movements described above, we will see how even a tiny move in exchange rates can result in substantial gains or losses. This is how forex traders make money.
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