In the world of trading, currencies always come in pairs. For example, we often talk about the euro/US dollar pair (EURUSD),or the US dollar/Japanese yen pair (USDJPY), or maybe even the Canadian dollar/Swiss franc pair (CADCHF) for those interested in more exotic combinations. The fact that currencies are always referred to in pairs may seem confusing to novice traders, but there’s logic to the madness and it’s a lot simpler than you may think. An easy way to grasp the concept of how currency pairs work is to look at them through the framework of watching sports.
The importance of competition
When you watch sports, you never watch your favourite team on its own; you always watch a match between your team and another team. The competition is what makes the sport, and your team’s performance versus that of the opposing side becomes the measure by which to judge its standing in the competition.
Much like sports, forex by definition requires two “opponents”. You can’t understand the value of the USD unless you know what you’re valuing it against, much like you can’t state that a team will win their match if you don’t know who they’re playing against. In order to engage in forex trading you need to estimate that the value of one currency will rise or fall against another – much like in football you would speculate that Team A will win or lose against Team B. In order to know which currency in the pair will ‘prevail’ in this competition of currency values, you have to take multiple variables into consideration. How has the match historically played out between them? Is one team on a strong winning streak, or does one have less favourable odds because a key player is on the bench? In forex too you have to watch the ‘match’ between the two currencies that interest you to understand the standing of each and how they relate and compare to each other.
Adjusting the game plan
Every team has its strong points and weak points depending on its composition. One team may have a very strong defence line, while another has the best offensive player in the tournament. The way a team plays a particular match, however, doesn’t solely depend on its own composition, but also on the composition of its opponent. Before a match, the coach will try to analyse the challenges involved in a game in order to devise a winning strategy.
Currencies work in a similar way, but instead of coaches and players they have central bankers and monetary policy. Although each central bank traditionally favours certain tools for dealing with specific financial issues, policymakers can adjust their plan of action in order to deal with new challenges in effective ways. When dealing with banking crises, the European Central Bank (ECB), for example, did not traditionally employ Quantitative Easing (QE) – a tactic favoured by the US Federal Reserve. In dealing with the current economic crisis, however, the ECB changed its strategy and introduced a QE programme similar to the one that helped the US exit its last major financial crisis.
The sentiments at play
No matter how technical we get with sports, we all know that sentiment and psychology play a large role in determining victories and losses. If the players of a team enter the field with the wrong psychology – whether feeling too confident in themselves against an opponent or feeling low after a big loss during a previous game – the chances of performing to the best of their abilities dramatically decrease.
Sentiment plays a large role in currency trading as well. If traders feel strongly about the way a currency might perform, either in a positive or negative way, they can overbuy or oversell based on sentiment alone. Market sentiment can, therefore, change the value that one would anticipate a currency pair to have. The depreciation of the US dollar against the euro through the second half of April 2015, for example, provides one such example of sentiment affecting the value of a currency pair. Despite the Eurozone’s inability to find a solution to the Greek situation before April’s deadline, the expectation of a dovish FOMC statement at the end of the month pushed the value of the dollar lower, and the value of the euro higher than the data and numbers about the health of each economy could justify.
Forex trading, of course, is not a sports game, but an investment opportunity that requires traders to carefully consider the risks involved before engaging in it. Looking at currency pairs, however, the framework we use to analyse sports teams and sports matches can help us get a better understanding of how currency pairs work and how they relate to one another by comparing them to a process we’re already familiar with.
Jameel Ahmad
