The base currency is the first currency listed in a currency pair, such as USD/EUR (where the U.S. dollar is the base currency). The second currency is called the quote or counter currency. If you are “long” the currency pair, you expect the base currency to rise in terms of the quote/counter currency. If you are “short” the pair, you expect the opposite.
Currency pairs are used for everything from simple exchanges when visiting a foreign country to highly leveraged trading. It’s imperative to understand which currency is the base and how transactions function around that currency. Let’s go over how currency pairs work, and why the base currency matters.
Definition and Examples of Base Currency
The base currency is the first currency in a currency pair. The second is the quote or counter currency. The quote for the currency pair shows how much of the quote currency it takes to purchase one unit of the other.
Currency pairs are used because you are always selling one currency and buying the other. You sell the counter currency and buy the base currency. In a currency trade—assuming it is an investment or speculation and not being done for a simple transaction—when you take a long position, you are betting that the base currency will go up in terms of the counter currency.
The currency pair is spelled out as the three-letter abbreviation for the base currency, then the abbreviation for the counter currency. There are several “major” currency pairs that are traded most often; foremost among those is USD/EUR.
With USD/EUR, the U.S. dollar is the base currency and the euro is the counter currency. A quote of 0.8472, for example, means it takes 0.8472 euros to buy one dollar.
The U.S. dollar is the base currency for most of the major currency pairs, including USD/JPY (Japanese yen as the quote currency), USD/CHF (Swiss franc), and USD/CAD (Canadian dollar).
There are two exceptions in major pairs when the U.S. dollar is not the base currency: GBP/USD (British pound as base currency) and AUD/USD (Australian dollar as base currency), although both still include the U.S. dollar in the pair, just not as the base currency.
How a Base Currency Works
When you trade currencies, you go long the base currency and short the other. Local shifts in interest rates, trade deficits, and economic growth can all be reasons to favor one currency over another.
Trading is done on regulated exchanges called Forex (short for “foreign exchange”) and off-exchange markets.
Currency pairs are quoted in incremental units called “pips.” A pip is the fourth digit after the decimal point in a quote, equal to .01% of one currency unit. If the quote is 0.8472, a move of one pip would change the quote to 0.8473 or 0.8471.
Like stocks, currency pairs have bid-ask prices. The buyer pays the ask price and the seller gets the bid price. The market maker earns the spread, or difference between the two prices. Exchanges compete on spread prices to attract customers.
More commonly traded currency pairs, such as the major pairs discussed above, have lower spreads because they occur more often, which allows the exchange to make money on the volume.
Trades are done in “lots,” which are 100,000 units of the base currency. This may seem like a large minimum investment (and it is), but currency trading can have margin factors as low as 2% depending on the currency pair. That means if you trade one lot with dollars as the base currency, you only need $2,000 in the account to control $100,000 in the trade.
What It Means for Individual Investors
It’s imperative to understand the base currency when making any currency pair trades, not only because the base currency determines the direction of the trade (if you go long/buy the pair, you believe the base currency will go up relative to the quote currency), but also because of the size of the lot. For example, if you do a trade with the U.S. dollar as base currency, it is going to be based on a $100,000 lot size, whereas if you do a trade with a currency worth far more or less than the U.S. dollar, it could have a big impact on the margin requirement for your account.
- The base currency is the first currency stated in a currency pair quote. For example, in USD/EUR, the U.S. dollar is the base currency.
- The second currency is the quote currency, which states how much of the quote currency is required to buy one unit of the base currency.
- The base currency dictates the direction of the trade. If you buy the pair, you’re betting the base currency will go up relative to the quote.