The forex (or foreign exchange) market is the world's largest and most liquid market, with trillions of dollars traded on any given day between millions of parties. For those just getting started in the forex market, one of the first steps is to gain familiarity with some of the more commonly traded currencies and their popular uses in not only the forex market but also in general. Here is a look at six popular currencies with which all forex observers should be acquainted and some of the underlying traits and characteristics of each currency.
1. The U.S. Dollar
First and foremost is the U.S. dollar, which is easily the most traded currency on the planet. The USD can be found in a pair with all of the other major currencies and often acts as the intermediary in triangular currency transactions. This is because the USD acts as the unofficial global reserve currency, held by nearly every central bank and institutional investment entity in the world.
In addition, due to the U.S. dollar's global acceptance, it is used by some countries as an official currency, in lieu of a local currency, a practice known as dollarization. The U.S. dollar also may be widely accepted in other nations, acting as an informal alternative form of payment, while those nations maintain their official local currency.
The U.S. dollar is also an important factor in the foreign exchange rate market for other currencies, where it may act as a benchmark or target rate for countries that choose to fix or peg their currencies to the USD's value. China, for instance, has long had its currency, the yuan or renminbi, pegged to the dollar, much to the disagreement of many economists and central bankers. Quite often countries will fix their exchange rates to the USD to stabilize their exchange rate, rather than allowing the free (forex) markets to fluctuate its relative value.
One other feature of the USD that novices in forex need to understand is that it is used as the standard currency for most commodities, such as crude oil and precious metals. Thus, these commodities are subject not only to fluctuations in value due to the basic economic principals of supply and demand but also to the relative value of the U.S. dollar, with prices highly sensitive to inflation and U.S. interest rates, which directly affect the dollar's value.
2. The Euro
Although still relatively new to the world stage, the euro has become the second most traded currency, behind only the U.S. dollar. The euro is also the world's second-largest reserve currency. The official currency of the majority of the nations within the eurozone, the euro was introduced to the world markets on January 1, 1999, with banknotes and coinage entering circulation three years later.
Along with being the official currency for most eurozone nations, many nations within Europe and Africa peg their currencies to the euro, for much the same reason that currencies are pegged to the USD – to stabilize the exchange rate..
With the euro being a widely used and trusted currency, it is very prevalent in the forex market and adds liquidity to any currency pair it trades within. The euro is commonly traded by speculators as a play on the general health of the eurozone and its member nations. Political events within the eurozone can often lead to large trading volumes for the euro, especially in relation to nations that saw their local interest rates fall dramatically at the time of the euro's inception, notably Italy, Greece, Spain and Portugal. The euro may be the most "politicized" currency actively traded in the forex market.
3. The Japanese Yen
The Japanese yen is easily the most traded currency out of Asia and viewed by many as a proxy for the underlying strength of Japan's manufacturing-export economy. As Japan's economy goes, so goes the yen (in some respects). Many use the yen to gauge the overall health of the Pan-Pacific region as well, taking economies such as South Korea, Singapore and Thailand into consideration, as those currencies are traded far less in the global forex markets.
The yen is also well known in forex circles for its role in the carry trade (seeking to profit from the difference in interest rates between two currencies). Japan has basically had a zero interest rate policy for more than two decades, and traders have borrowed the yen at next to no cost and used it to invest in other higher yielding currencies around the world, pocketing the rate differentials in the process. With the carry trade being such a large part of the yen's presence on the international stage, the constant borrowing of the Japanese currency has made appreciation a difficult task. Though the yen still trades with the same fundamentals as any other currency, its relationship to international interest rates, especially with the more heavily traded currencies such as the U.S. dollar and the euro, is a large determinant of the yen's value.
4. The Great British Pound
The Great British pound, also known as the pound sterling, is the fourth most traded currency in the forex market. It also acts as a large reserve currency due to its relative value compared to other global currencies. Although the U.K. is still an official member of the European Union, it chose not to adopt the euro as its official currency for a variety of reasons, namely historic pride in the pound and maintaining control of domestic interest rates. For this reason, the pound can be viewed as a pure play on the United Kingdom. Forex traders will often base its value on the overall strength of the British economy and political stability of its government. Due to its high value relative to its peers, the pound is also an important currency benchmark for many nations and acts as a very liquid component in the forex market.
5. The Canadian Dollar
Also known as the loonie, the Canadian dollar is probably the world's foremost commodity currency, meaning that it moves in step with the commodities markets – notably crude oil, precious metals and minerals. With Canada being such a large exporter of such commodities, the loonie is very volatile to movements in their underlying prices, especially that of crude oil. Traders often trade the Canadian dollar to speculate on the movements of these commodities or as a hedge to their holdings of those underlying contracts.
Additionally, being located in such close proximity to the world's largest consumer base - the United States - the Canadian economy, and so the Canadian dollar, is highly correlated to the strength of the U.S. economy and movements in the U.S. dollar as well.
6. The Swiss Franc
Last is the Swiss franc, which, much like Switzerland, is viewed by many as a "neutral" currency. More correctly, the Swiss franc is considered a safe haven within the forex market, primarily due to the fact that the franc tends to move in a negative correlation to more volatile commodity currencies, such as the Canadian and Australian dollars, along with U.S. Treasury yields. The Swiss National Bank has actually been known to be quite active in the forex market to ensure that the franc trades within a relatively tight range, to reduce volatility and keep interest rates in check.
The Bottom Line
Every currency has specific features that affect its underlying value and price movements relative to other currencies in the forex market. Understanding what moves a currency and why it moves is a pivotal step in becoming a successful participant in the forex market.