A cross-currency pair excludes the U.S. dollar. For traders who are open to exploring cross-currency pairs, there are additional opportunities beyond the highly liquid U.S. dollar, which dominates global trading volume.
Trading cross-pairs alongside the major currency pairs can significantly expand your range of trading instruments, opening up more opportunities for you to explore. Before diving into a strategy that involves cross-currency trading, it's important to be aware of a few potential obstacles. Although the benefits of trading in the cross-currency markets generally outweigh the drawbacks, it's crucial to understand these speed bumps.
A cross rate can also be used to describe a currency pair or transaction that doesn't involve the currency of the party initiating the transaction. We look at the importance of cross rates in forex trading, including how they are calculated, what they represent, and how traders use them.
What Is a Cross Rate?
A cross-rate is a foreign currency exchange transaction that involves two currencies, each valued against a third currency. The U.S. dollar (USD) typically determines the values of the currency pairs traded in foreign currency exchange markets.
As the base currency, the U.S. dollar maintains a constant value of one. Certain currency pairs have an inverse relationship where the dollar is not the primary currency.
Trading a cross-currency pair involves two transactions. The trader begins by exchanging one currency for its equivalent in U.S. dollars. Typically, traders exchange currencies when they convert U.S. dollars into another form of currency.
Understanding the Cross Rate
Typically, we determine the value of each of the two traded currencies using the U.S. dollar. Upon calculating the cross rate between the British pound and the euro, you would observe that the British pound held a value of approximately 1.25 to one U.S. dollar, whereas the euro held a value of approximately 1.07 to one.
Due to its widespread recognition as the world's primary reserve currency, the forex market quotes the majority of currency exchange rates against the US dollar. However, cross rates are crucial when traders or investors wish to exchange one foreign currency directly for another foreign currency without first converting it to USD.
Calculating cross-rates necessitates using the exchange rates of the two currencies with respect to the USD as an intermediary step. Let's consider a scenario where a trader needs to determine the exchange rate between the Euro (EUR) and the Japanese Yen (JPY), as an economist would analyze it. In this case, if the trader only has access to the EUR/USD and USD/JPY rates, they can calculate the EUR/JPY cross rate by multiplying the EUR/USD rate by the USD/JPY rate.
Trading Instruments
Utilizing forex cross-currency pairs offers a significant advantage as it expands the range of trading instruments, providing you with more opportunities to trade. If you exclusively trade the major currency pairs, you have six different securities to consider when formulating your trading perspective. By incorporating cross-currency pairs into your trading strategy, you can create numerous combinations to reflect your forex trading perspective.
Experienced traders are always on the lookout for potential opportunities in forex cross-pairs. Typically, currency markets tend to follow trends around 30% of the time. On average, currency markets tend to remain within a certain range about 70% of the time. This phenomenon is particularly prevalent in highly correlated forex crosses.
By incorporating cross-currency pairs into your list of instruments to monitor, you are expanding the possibilities for trading and gaining exposure to a diverse range of products with ample volatility to shape and integrate your trading strategy.
The Major Currency Pair
The majority of transactions on the forex market involve major currency pairs. If a financial news site quotes the USD/CAD at 1.28, it means that one U.S. dollar is equivalent to 1.28 Canadian dollars.
People often cite the Euro-Japanese yen exchange rate as a cross rate because it does not include the U.S. dollar. However, from a purely technical perspective, anyone outside of Japan or any of the countries that use the euro as their official currency classifies it as a cross rate.
People typically refer to a cross rate when neither the U.S. dollar nor any other currency is involved. People commonly use it to describe a trade or quote that does not include the U.S. dollar.
Examples of Major Cross Rates
While traders can quote various currency pairs against each other, the euro versus the British pound (EUR/GBP) and the euro versus the Japanese yen (EUR/JPY) are particularly popular. These two pairs are the only ones to appear in the top 10 most traded currency pairs. If the pair includes the euro, it becomes the base currency for the quote. If we include the pound, we consider the British pound as the base, disregarding the euro.
Examples of Minor Cross Rates
Less frequently traded cross rates in the interbank market include CHF/JPY and GBP/CHF. When it comes to cross-rates involving the Japanese yen, the usual practice is to quote the number of yen in relation to the other currency, regardless of what that currency may be.
When dealing with currencies that have a similar value and quoting convention, it is crucial to exercise caution to avoid any trading errors. The New Zealand dollar (NZD) traded at 1.08 against the Australian dollar (AUD) in late December 2023. We value both these currencies in relation to the U.S. dollar. The value represents the amount of U.S. dollars required to purchase the foreign currency.
However, the quote does not provide any indication of which currency serves as the base. Given the larger economy's status, it is common practice in the market to use the stronger AUD as the base, given its status as the larger economy. The two currencies are trading at nearly the same value, which could lead to a potential misquote.
Exotic Forex Cross Currency Pairs
We use a few categories to broadly classify currency pairs. There are major currency pairs, major cross pairs, exotic currency couples, and minor currency pairs.
Currency pairs that are not as frequently traded on the foreign exchange market are referred to as exotic currency pairs. Developing nations in Africa, South America, Asia, and the Middle East typically find exotic currency pairs. Because exotic currency pairs typically have wide bid-offer spreads, longer-term strategies with profit targets significantly higher than the bid-offer spread are frequently necessary.
The yield differential favouring the less stable currency is one of the advantages of trading exotic cross-currency pairs. This compensates you for holding onto a potentially erratic and risky currency. Although incredibly tempting, this kind of tactic can be very dangerous.
In addition, when a nation's currency is weaker than others, its goods and services are less expensive than those of its rivals. For a central bank trying to encourage growth, this can be highly alluring.
In order to prevent currency appreciation, which can hinder the growth of exports, a nation will frequently tie its currency to the currencies of other nations rather than allowing it to float. The central bank typically handles the daily trading activity that maintains the currency's value when a nation pegs its currency to another.
Significance of Cross Rates
Cross rates are essential for:
- International Transactions: Cross rates provide direct currency conversions without using USD, which simplifies transactions when conducting business internationally.
- Investments: When making investments in foreign currencies and assets, investors use cross rates to assess the risks and possible rewards.
- Currency risk: Cross rates are a tool used by businesses to manage currency risk, particularly when working with other currencies.
- Opportunities for Arbitrage: Traders can profit risk-free by taking advantage of price differences in cross rates.
In the forex market, cross rates are essential since they allow for direct currency conversions between several foreign currencies. They facilitate cross-border transactions, assist investors in making decisions, and give traders the chance to profit from fluctuations in currency prices.
Fundamental Analysis
When trading cross-pairs, it is useful to examine economic data because the interest rate differential may influence the path that the currency pair will take in the future. The process of analyzing interest rates and other pertinent economic data points is commonly known as fundamental analysis.
When looking over economic data for a certain nation, you should look into and ascertain what causes economic growth and how that growth will affect the nation's economy in the future.
Generally speaking, demand for a nation's currency and the ensuing exchange rate should grow when its economy is performing well. Conversely, if a nation's economy is struggling and producing poor economic data, the demand for its currency may decrease. You can examine the relationship between economic statistics and a nation's currency value using basic analysis.
Pros and cons of cross rate in forex trading
Pros
By adding cross currency pairs, you can find pairs that are on the move, which might not be the case if you are just evaluating the majors
Many cross currency pairs are highly correlated and move in lock step which can provide range trading opportunities
Exotic cross currency pairs can be relatively unpredictable and highly volatile, sometimes well beyond the historical volatility that you would experience by trading the major currency pairs
While the trading risks and costs can be higher, the benefits of adding the more liquid cross currency pairs to your arsenal are worth it
Cons
Cross currency pairs usually have a higher transaction cost relative to major currency pairs as the bid offer spread on the spot rate and forward rate are wider
The time zone were you transact your trades will also play a role in determining the cost of a transaction
The risks associated with trading crosses can also be significant, because many times you are dealing with less developed economies, so you need to monitor multiple political and economic situations more carefully
Conclusion
The interbank market actively quotes the big crosses, but their bid-offer spreads are marginally higher than those of the major dollar-based pairs. The minor crosses typically have substantially bigger spreads. We must create a quote from the bids and offers in the component currencies relative to the US dollar, as some do not receive any quotation at all.
