The foreign exchange market, commonly known as the FX market, is the largest financial market in the world. It entails trading in several currencies to generate profits. Foreign exchange traders frequently work with popular currency pairings, including EUR/USD (Euro/US Dollar), GBP/USD (British Pound/US Dollar), and USD/JPY (US
Dollar/Japanese Yen). But traders may also trade cross-pairs in the currency market. In this post, we’ll go over cross-pairs’ definition and operation.
Table of Contents
What is a Currency Pair?
A currency pair is the end product of weighing a country’s currency by pairing it with another. EUR/INR represents the currency pair pairing the Euro (EUR) with the Indian Rupee (INR). In this pairing, EUR denotes the base currency, representing the first currency in the pair, while INR signifies the quote currency, standing as the second currency. If the EUR/INR pair is quoted at 88.50, it implies that 1 Euro is equivalent to 88.50 Indian Rupees.
So, for instance, if someone intends to purchase Euros using Indian Rupees and the EUR/INR rate stands at 88.50, they would need 88.50 INR to acquire 1 Euro. Conversely, if they were to sell 1 Euro, they would receive 88.50 Indian Rupees in return, based on the prevailing exchange rate. This rate fluctuates based on market conditions and influences currency exchange between the Euro and the Indian Rupee in the forex market.
Emergence of Cross Currency Pairs
A currency market was required after World War II due to the expansion of international trade. Most currencies were exchanged in terms of US Dollars as the US economy emerged as the strongest internationally. However, when globalisation spread, and commerce between nations grew, there was a requirement to exchange foreign currencies. Any currency exchange at first needed the US Dollar to act as an intermediary. If a trader needed to convert Euros to Japanese Yen, they would have to first convert Euros to US Dollars. After that, they can use the US Dollars to buy Japanese Yen. So, the process requires two transactions. Cross-currency pairs have appeared in recent years as a result of the explosive growth of the FX market. In cross-currency pairs, direct currency exchanges without the use of US Dollars are possible. Cross-currency pair trading in India is also slowly on the rise.
Calculating Currency Cross Rates
Let’s now walk you through the process to find the ask and bid prices for a currency cross. Currency cross rates are determined by comparing each currency in question to a common currency, typically the US Dollar, to derive an indirect exchange rate between
the two currencies. Here’s an example using EUR/INR to find out how many Indian Rupees (INR) equal 1 Euro (EUR):
Firstly, let’s assume we have the following information:
- EUR/USD exchange rate = 1.20 (which means 1 Euro equals 1.20 US Dollars)
- USD/INR exchange rate = 75.00 (which means 1 US Dollar equals 75 Indian Rupees)
To calculate EUR/INR without a direct quote, you can use the indirect method via USD:
- Calculate the value of 1 Euro in US Dollars using the EUR/USD exchange rate:
- 1 Euro = 1.20 US Dollars (given exchange rate)
Determine the value of 1 US Dollar in Indian Rupees using the USD/INR exchange rate:
- 1 US Dollar = 75 Indian Rupees (given exchange rate)
Combine the two calculations to find 1 Euro in Indian Rupees:
- 1 Euro = (1 Euro in US Dollars) × (1 US Dollar in Indian Rupees)
- 1 Euro = 1.20 US Dollars × 75 Indian Rupees = 90 Indian Rupees
Therefore, based on the given exchange rates, 1 Euro would be equivalent to 90 Indian Rupees in the EUR/INR cross rate calculated indirectly via USD. Please note that actual rates fluctuate due to market conditions and may differ slightly from calculated values.
What are the Uses of Cross-Currency Transactions?
Debt transactions involving various currencies typically make use of cross-currency swaps that allow for the borrowing of money at a reduced rate.
- An agreement between two parties to exchange principal and interest payments in several currencies is known as a currency swap.
- Cross-currency trades and foreign currency deposits are both utilised by investors to hedge against foreign currency movements.
- Consequently, investors regularly use multi-currency transactions to lower their financial risks.
- Investors can also employ cross-currency trading as a strategy for arbitrage to benefit.
- Cross-currency transactions are a part of cross-border payments.
- There are possibilities for receiving and sending cross-border payments for customers of banks that support such transactions.
- Additionally, it increases demand for international payments and trade.
Benefits of Cross Currency Pairs
Diversification
It is essential to invest in a variety of financial products to maximise your portfolio’s returns. Make a currency investment decision that will allow you to increase your profit margin through cross-trading. It would, however, need detailed observation of currency price patterns and the political and socioeconomic factors driving these moves.
Hedging In the context of investing, hedging generally refers to the desire to balance out prospective losses from one investment with potential gains from another. The best way to protect against the volatility of cross-currency rates and maximise return on investment is to invest in many cross-currency pairs.
Forex Trading and Speculation
Cross-currency pairs are great tools for boosting transaction volumes in forex trading. For instance, during the Brexit process, it was possible to place trades immediately on the EUR/GBP currency pair from anywhere in the globe. But if you want to avoid cross pairings, you have to make the transaction individually on USD/GBP and then USD/EUR.
Risks of Trading Cross Currency Pairs
Understanding the risks associated with trading cross-currency pairs is crucial. The interests are one of the key variables that significantly influence those risks. Additionally, trading may occur in any cross-currency pairs, but settlement may occur in a different currencies. So, the earnings may change as a result. Additionally, when beginning cross-currency trading, you should pick currencies that behave predictably against the dollar. This guarantees that they are also stable when compared to other currencies.
Conclusion
Cross pairings are currency pairs that are traded against a major currency but do not include the US dollar. They function like the major currency pairings. They can provide
more trading possibilities, diversification, less volatility, and larger potential profits. Trading cross pairings, however, has certain potential risks. These include larger spreads and less liquidity, which traders should be aware of. Before trading any forex pair, especially cross pairings, it is crucial to do careful market research and create a solid trading plan.
