A:

In forex markets, currency trading is conducted most frequently among the U.S. dollar, the Japanese yen, the euro, the British pound and the Canadian dollar.

A currency pair such as EUR/USD, for example, represents the relationship between the euro and U.S. dollar. The first currency is the base currency and the second currency is the quote currency. So, to buy EUR/USD at 1.1200 on a trade for 100,000 currency units, you would need to pay US$112,000 (100,000 * 1.12) for 100,000 euros.

Four major currency pairs are the most traded and have the highest volume. These are known as the major pairs. They are the EUR/USD, USD/JPY, GBP/USD and the USD/CHF. These pairs all contain the U.S. dollar. In yen-denominated currency pairs, a pip is only two decimal places, or 0.01. This is 1/100th of a cent. Currencies are often traded in lots that are 1,000 units of the underlying currency.

A pip, an acronym for "price interest point", is a tool of measurement related to the smallest price movement made by any exchange rate. Currencies are usually quoted to four decimal places, meaning that the smallest change in a currency pair would be in the last digit. This would make one pip equal to 1/100th of a percent, or one basis point. For example, if the currency price we quoted earlier changed from 1.1200 to 1.1205, this would be a change of five pips.

[Note: Pips are one of the most fundamental concepts to understand when trading currencies, but there are countless other concepts that forex traders need to know to be successful. Investopedia Academy's Forex Trading course will teach you a proven strategy that you can leverage when trading all currencies. Check it out today!]

To get the value of one pip in a currency pair, an investor has to divide one pip in decimal form (i.e., 0.0001) by the current exchange rate, and then multiply that number by the notional amount of the trade.

Keeping with our earlier example for the EUR/USD currency pair, let's say the value of one pip is 8.93 euros ((0.0001/1.1200) * 100,000). To convert the value of the pip to U.S. dollars, just multiply the value of the pip by the exchange rate, so the value in U.S. dollars is $10 (8.93 * 1.12).

The value of one pip is always different between currency pairs because of differences between the exchange rates of various currencies. A phenomenon does occur when the U.S. dollar is quoted as the quote currency. When this is the case, for a notional amount of 100,000 currency units, the value of the pip is always equal to US$10.

To learn more, see "Common Questions About Currency Trading," "A Primer on the Forex Market" and "Forces Behind Exchange Rates."

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