Relative Valuation In The Foreign Exchange Market
The main difference between trading in the foreign exchange market and trading in
all other financial markets is the difference between solitary valuation versus relative valuation. Solitary valuation is common sense for most people and is the way that most investors understand stock prices and other financial markets, but relative valuation is a little bit more tricky and it is what can make forex trading more complicated in some ways than stock or traditional commodity trading.
When you look at a stock market quote you will usually see the stock value quoted in a dollar amount, and this of course is the normal way that we value things in finance. However, valuing a currency is a different process, because you cannot value the US dollar in terms of dollars so it then becomes important to value one currency in terms of another currency. It is for this reason that all foreign exchange transactions take place with currency pairs, and this is called relative valuation where one currency's value is listed relative to another currency.
The Base Currency And The Quote Currency
In a currency pair such as the EUR/USD, the first currency listed in the pair is called the "base currency" and the second currency listed is called the "quote currency." It is important to remember that all exchange rate quotes are quoted in established currency pairs, and while to the untrained eye it may seem like the pairing of different currencies is done in a random order which then became the industry standard, there is actually a fairly sound logic behind the ordering of most of the major currency pairs.
For most of the major currency pairs that are traded we see that the US dollar is usually quoted as the base currency such as the USD/JPY and USD/CHF pairs. The reason this is so is because the USD has typically and historically had a higher value than these currencies, and so it makes sense to keep it valued at 1 so that any changes in value of the other currency become easily apparent. The only exceptions to this rule are the EUR, GBP, and AUD in which these currencies have a value that is as high as or higher than the USD so it makes sense to list these as the base currencies for the ease of calculation.
Once you understand the simple common sense behind these exchange rates, the calculations that need to be performed become much easier to understand. Most large newspapers and especially financial newspapers will have a currency table that is updated daily. If you read through this table looking for the value of a currency pair that you are trading but instead this value is reversed from its normal order (such as displaying the US dollar against the Euro with the dollar as the base currency with a value of 1), all you would need to do to get the normal currency pair valuation is to take that value and divide it by one to effectively switch the base currency and the quote currency.
Understanding this relationship between the quote currency and the base currency also becomes very important when it comes to reading and searching for signals from price charts, because you must know which currency is increasing or decreasing in value when the currency pair value moves up or down. If you were looking at the price chart for EUR/USD and you watched the price move from 1.3600 to 1.3700, this would indicate that the dollar has lost value relative to the Euro. Keep in mind the basic common sense of these financial relationships and the concept of relative valuation becomes simple to understand.
by: Ricky Weber
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