Currency Pairs Explained: Reciprocal Currency and Its Applications
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Summary:
Reciprocal currency pairs in the forex market involve the U.S. dollar (USD) as the quote currency, not the base currency. This article explores what reciprocal currencies are, examples, how they’re quoted, and their significance in foreign exchange trading.
What is a reciprocal currency?
In the foreign exchange (forex) market, a reciprocal currency is a currency pair where the U.S. dollar (USD) serves as the quote currency rather than the base currency. In simpler terms, it’s a currency pair quoted in terms of U.S. dollars per unit of foreign currency instead of units of currency per dollar.
A typical example of a reciprocal currency pair is the EUR/USD, where a quote of 1.20 means that one euro buys 1.20 U.S. dollars.
Understanding reciprocal currencies
In most USD currency pairs, the U.S. dollar is the base currency, appearing first in the quote. For instance, in USD/JPY or USD/CAD, the quote indicates how many units of a foreign currency one U.S. dollar can purchase.
However, reciprocal currencies are quoted differently. They’re commonly referred to as “European” terms, meaning the currency other than the U.S. dollar is the base currency. Therefore, a reciprocal currency pair involves the U.S. dollar and another currency, but the USD is not the first currency quoted.
Example of reciprocal currency
An illustrative example of a reciprocal currency is the NZD/USD. Here, the New Zealand dollar is the base currency, and the U.S. dollar is the quote currency. So, a quote of 0.70 means that one New Zealand dollar can be exchanged for 70 U.S. cents.
Similarly, the EUR/USD exchange rate is expressed in dollar terms despite the euro being listed as the base currency. For instance, if the EUR/USD rate is $1.15, it means 1 euro is equivalent to $1.15.
What is a reciprocal currency arrangement?
A reciprocal currency arrangement, also known as a swap line, is an agreement between two nations to maintain specific money supplies of each other’s currencies. These agreements enhance liquidity between nations and global financial markets, facilitate more efficient financial transactions, maintain reserve requirements, and establish exchange rates.
What is a currency pair?
A currency pair is a quotation of the value of two currencies, where one currency’s value is quoted against the other. The first currency in the pair is the base currency, and the second is the quoted currency. Currency pairs reveal how much of the quote currency is required to purchase one unit of the base currency.
How do you find the reciprocal exchange rate?
To find the reciprocal exchange rate, you divide 1 by the current exchange rate of the two currencies. For example, if the USD/EUR exchange rate is 0.89, the reciprocal exchange rate of EUR/USD would be 1 divided by 0.89, which equals approximately 1.12.
What are the two ways to quote a currency?
Currencies can be quoted as direct quotations or indirect quotations. In a direct quotation, one unit of a foreign currency is quoted in terms of the corresponding units of the domestic currency. Conversely, an indirect quotation expresses one unit of a domestic currency in terms of the equivalent foreign currency.
How are foreign currency options quoted?
Foreign exchange options are priced based on the intrinsic value plus the time value, known as the FX option premium. The intrinsic value represents the difference between the converted currencies using the strike rate and forward rate.
The bottom line
A reciprocal currency in foreign exchange trading involves the USD as the quote currency, not the base currency. It’s quoted in terms of U.S. dollars per unit of foreign currency. Reciprocal currencies are significant in the FX market, with common examples including EUR/USD, GBP/USD, and AUD/USD.
Frequently asked questions
What is a reciprocal currency arrangement?
A reciprocal currency arrangement is an agreement between two nations to maintain a specific money supply of each other’s currencies. This enhances liquidity between the nations and in the global financial markets, allowing for more efficient financial transactions and setting exchange rates. Reciprocal currency arrangements are also known as swap lines.
How are foreign currency options quoted?
Foreign exchange options are priced based on the intrinsic value plus the time value, known as the FX option premium. The intrinsic value represents the difference between the converted currencies using the strike rate and forward rate.
Why are reciprocal currency pairs less common?
Reciprocal currency pairs are less common than USD-based pairs because most forex trading involves the USD as the base currency. However, reciprocal currencies are still significant in the FX market, providing opportunities for traders to diversify their portfolios and capitalize on currency fluctuations.
Key takeaways
- Reciprocal currencies involve the U.S. dollar (USD) as the quote currency, not the base currency.
- They are less common than USD-based currency pairs and are sometimes referred to as “European” quotations.
- Reciprocal currency arrangements are agreements between nations to maintain specific money supplies of each other’s currencies.
- To find the reciprocal exchange rate, divide 1 by the current exchange rate of the two currencies.
- Currencies can be quoted as direct or indirect quotations, depending on which currency is listed first.
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