A currency pair (e.g., EUR/USD, GBP/USD, USD/JPY) consists of two currencies, each with a defined role:

• Base Currency

The first currency in a pair is the base currency (e.g., EUR in EUR/USD). It serves as the reference point for the exchange rate. When the EUR/USD exchange rate rises, one euro can be exchanged for more US dollars, indicating that the euro is appreciating against the US dollar.

• Quote Currency

The second currency in a pair is the quote currency (e.g., USD in EUR/USD). The exchange rate indicates how many units of the quote currency are needed to purchase one unit of the base currency. If the EUR/USD exchange rate is 1.1000, it means one euro can be exchanged for 1.1000 US dollars.

The forex market primarily uses two pricing conventions: direct and indirect quotation.

Direct Quotation

A direct quotation expresses how much domestic currency is needed to buy one unit of foreign currency. This method is used by most countries, including China. Example:

USD/JPY 110.50/110.55

Buying 1 USD costs 110.50 JPY

Selling 1 USD yields 110.55 JPY

The spread (0.05 JPY) represents dealer fees and trading costs.

Economic Fundamentals

Economic fundamentals play a key role in exchange rate fluctuations. These include economic growth, inflation rates, and interest rates.

• Economic Growth

A strong economy with rapid GDP growth attracts foreign investment, increasing demand for the country's currency and driving its value higher.

• Inflation Rate

A low inflation rate stabilizes prices and maintains the purchasing power of a currency, making it more attractive to investors and increasing its exchange rate. Conversely, high inflation erodes purchasing power, discouraging investors, and causing depreciation.

• Interest Rate Levels

Higher interest rates attract foreign investors seeking better returns, increasing demand for the currency and strengthening its exchange rate.

Policy Factors

• Monetary Policy

Central banks use interest rate adjustments and money supply control to influence exchange rates:

Raising interest rates attracts investors, increasing demand for the currency and pushing its value higher.

Expanding the money supply can cause depreciation, as more money in circulation reduces its relative value.

Example: Japan’s long-term quantitative easing has increased its money supply, leading to a weaker yen.

• Fiscal Policy

Government spending and taxation also impact exchange rates:

Increased government spending on infrastructure, education, and healthcare stimulates economic growth, attracting foreign capital and strengthening the currency.

Lower taxes encourage investment and consumption, boosting the economy and exchange rate.

Higher taxes may reduce economic activity, weakening demand for the currency.

Other Factors

• Geopolitical Events

Wars, political conflicts, and economic sanctions can trigger capital outflows from affected countries, weakening their currencies.

• Market Sentiment & Speculation

Investor sentiment and expectations can drive currency values. Speculative trading can cause sharp fluctuations, sometimes leading to overvaluation or undervaluation.

• Balance of Payments

A current account surplus supports a currency. For example, Japan's consistent 4% current account surplus has helped maintain the yen’s value despite loose monetary policies. Conversely, the eurozone’s 2022 trade deficit contributed to the euro reaching a 20-year low against the dollar.

• Currency Pair Selection

Before trading, investors analyze historical exchange rate trends and economic cycles to forecast potential currency movements.

• Cost Control

The spread—the difference between the bid and ask price—is the primary cost in forex trading. A trade becomes profitable only when price movements exceed the spread. Some trading platforms also charge additional transaction fees.

• Risk Management

Effective risk management is crucial in forex trading:

- Leverage allows traders to control larger positions with less capital but also amplifies losses.

- Stop-loss and take-profit orders help limit losses and secure profits.

- Diversifying trades and managing position sizes reduce exposure to extreme market movements.