A base currency is the primary currency that is used as a reference in foreign exchange (forex) transactions or when comparing the value of different currencies. In a currency pair, the base currency is the first currency listed, and its value is always expressed as 1 unit, while the value of the second currency, known as the quote or counter currency, fluctuates relative to the base currency.
For example, in the currency pair EUR/USD, the euro (EUR) is the base currency, and the US dollar (USD) is the quote currency. If the exchange rate for EUR/USD is 1.20, it means that 1 euro can be exchanged for 1.20 US dollars. In this case, the value of the base currency (EUR) is fixed at 1 unit, while the value of the quote currency (USD) changes based on the prevailing exchange rate.
In the forex market, the most widely used base currency is the US dollar, followed by other major currencies such as the euro, the British pound, and the Japanese yen. However, any currency can technically be a base currency, depending on the context and the currency pairs being traded.
Understanding the concept of base currency is crucial for forex traders, as it helps them evaluate the relative value of different currencies, calculate profit and loss, and manage risk in their trading activities.
Example of a Base Currency
Let’s consider a fictional example involving the currency pair GBP/JPY (British pound/Japanese yen).
Imagine you are a forex trader, and you see that the current exchange rate for GBP/JPY is 150.00. In this currency pair, the British pound (GBP) is the base currency, and the Japanese yen (JPY) is the quote currency. The exchange rate of 150.00 means that 1 British pound can be exchanged for 150 Japanese yen.
Now, suppose you believe that the British pound will appreciate against the Japanese yen due to positive economic news from the United Kingdom. You decide to buy GBP/JPY, which means you are buying British pounds and selling Japanese yen simultaneously.
You purchase 10,000 units of the base currency (GBP), which is equivalent to £10,000. At the current exchange rate of 150.00, this transaction requires you to sell 1,500,000 Japanese yen (10,000 GBP x 150 JPY/GBP).
After a few days, the GBP/JPY exchange rate rises to 155.00, which means the British pound has indeed appreciated against the Japanese yen. You decide to sell your GBP/JPY position to lock in your profit. To do this, you sell your £10,000 (10,000 units of the base currency) and receive 1,550,000 Japanese yen in return (10,000 GBP x 155 JPY/GBP).
By trading the GBP/JPY currency pair and accurately predicting the appreciation of the base currency (GBP), you have made a profit of 50,000 Japanese yen (1,550,000 JPY – 1,500,000 JPY).
This example illustrates the concept of base currency in forex trading and demonstrates how understanding base and quote currencies can help traders make informed decisions and calculate their potential profit or loss.