Base Currency - Explained
What is Base Currency?
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Table of ContentsWhat is a Base Currency?How Does a Base Currency Work?Parts of a Currency PairSimultaneous MovementAcademics Research on Base Currency
What is a Base Currency?
The base currency is the first currency in a forex pair quotation referred to as the transaction currency. The second of the pair is the quote currency or the counter currency. The base currency can be used to represent all profits and losses of a company. This currency also functions as a company's domestic currency for accounting purposes.
How Does a Base Currency Work?
A base currency as used in the forex market indicates how much of the quote currency is needed to purchase one unit of the base currency. For example, in a pair of CAD/USD, the Canadian dollar (CAD) is the base currency while USD is the quote currency. As exemplified above, currency pairs use codes to indicate a specific currency. These three-letter codes are created and enforced by the International Organization for Standardization with provisions in ISO 4217. However, the most popular currency codes include USD, a description of the U.S. dollar, EUR for the euro, JPY for the Japanese yen, GPBfor the British pound, AUD for the Australian dollar, CAD for the Canadian dollar and CHF for the Swiss franc. These codes in a currency pair can be marked differently by using a slash or replaced with a period, a dash or nothing.
Parts of a Currency Pair
Currency pairs are usually marked with a slash or without a mark, for example, GBP/AUD, EUR/USD, USD/JPY, GBPJPY, EURNZD, and EURCHF. Where GPB is the base currency and AUD is the quote currency. This applies to others too. Currency pairs state how much of the quote currency is required to buy one unit of the provided base currency. This is done when the pair has an exchange rate. For example, an EUR/USD = 1.55 means that _1 is equal to $1.55. This by default states that in order to purchase _1, an investor must pay $1.55. The currency pair quotation is read in the same manner when selling the base currency. If a seller wants to sell _1, he will get $1.55 for it.
Investors purchase and sell currencies, this accounts for the reason why currency pairs are indicated as pairs. Investors purchase thinking that the base currency will appreciate compared to the quote currency. In the same vein, this pair can be sold if they think that the base currency will depreciate in value compared to the quote currency. An example of this is when an investor purchases EUR/USD, this simply means that the investor is purchasing euro and selling U.S. dollars simultaneously.
Academics Research on Base Currency
- The choice of numeraire currency in panel tests of purchasing power parity, Papell, D. H., & Theodoridis, H. (2001). The choice of numeraire currency in panel tests of purchasing power parity.Journal of Money, Credit and Banking, 790-803. We investigate the implications of the choice of numeraire currency on panel tests of purchasing power parity under the current regime of flexible exchange rates by conducting panel unit root tests with twenty-one different base currencies. We show that the conditions necessary for numeraire irrelevancy are not supported empirically, and that the choice of numeraire currency can and does matter for PPP. The evidence of PPP is stronger for European than for non-European base currencies. Distance between the countries and volatility of the exchange rates are the most important determinants of the results.
- On the perceived value of money: The reference dependence of currency numerosity effects, Wertenbroch, K., Soman, D., & Chattopadhyay, A. (2007). On the perceived value of money: The reference dependence of currency numerosity effects.Journal of Consumer Research,34(1), 1-10. Money illusion research shows that the nominal (face) value of money affects consumer perceptions of its real value. Recent mixed findings on consumer valuations in different currencies suggest that the underlying anchoring and adjustment processes are complex. We develop a framework to identify boundary conditions that specify the direction of anchoring effects on valuations in different currencies. Consumers anchor on the numerosity of the nominal difference between prices and salient referents (e.g., budgets) when evaluating transactions. Support for our framework comes from a series of experiments that evoke different reference standards. We discuss implications and opportunities for future research.
- Is there abase currencyeffect in longrun PPP?, Coakley, J., & Fuertes, A. M. (2000). Is there a base currency effect in longrun PPP?.International Journal of Finance & Economics,5(4), 253-263. The base currency effect in the purchasing power parity (PPP) literature refers to the stylized fact that tests on German mark real exchange rates are more likely to support mean reversion than analogous tests on US dollar rates. Using a panel of 19 OECD currencies, 19731997, we employ different panel unit root approaches to investigate the view that this effect can be attributed to neglected crosssectional dependence. While the results from panel methods which permit crosssectional dependence and heterogeneous serial correlation generally support longrun PPP, they provide no evidence of a base currency effect. Copyright 2000 John Wiley & Sons, Ltd.
- Global currency hedging, Campbell, J. Y., SerfatyDe Medeiros, K., & Viceira, L. M. (2010). Global currency hedging.The Journal of Finance,65(1), 87-121. Over the period 1975 to 2005, the U.S. dollar (particularly in relation to the Canadian dollar), the euro, and the Swiss franc (particularly in the second half of the period) moved against world equity markets. Thus, these currencies should be attractive to riskminimizing global equity investors despite their low average returns. The riskminimizing currency strategy for a global bond investor is close to a full currency hedge, with a modest long position in the U.S. dollar. There is little evidence that riskminimizing investors should adjust their currency positions in response to movements in interest differentials.
- Do momentum-based strategies still work in foreign currency markets?, Okunev, J., & White, D. (2003). Do momentum-based strategies still work in foreign currency markets?.Journal of Financial and Quantitative Analysis,38(2), 425-447. This paper examines the performance of momentum trading strategies in foreign exchange markets. We find the well-documented profitability of momentum strategies during the 1970s and the 1980s has continued throughout the 1990s. Our approach and findings are insensitive to the specification of the trading rule and the base currency for analysis. Finally, we show that the performance is not due to a time-varying risk premium but rather depends on the underlying autocorrelation structure of the currency returns. In sum, the results lend further support to prior momentum studies on equities. The profitability to momentum-based strategies holds for currencies as well.