A cross rate is an exchange rate between two currencies where neither of the currencies is the US dollar.
Cross rates facilitate transactions between two currencies that do not have a direct exchange rate, making them important for streamlining forex trading, simplifying international transactions, and diversifying investment portfolios.
Carry trades are obtained by dividing the exchange rate of one currency against USD by the exchange rate of the second currency against USD. The most actively traded cross rates include EUR/JPY, EUR/GBP, AUD/NZD, and EUR/SEK.
The benefits of taking cross rates include enhanced trading and diversification opportunities, arbitrage opportunities, and enhanced risk management through hedging. The challenges of cross rates include low liquidity risk, increasing complexity, high volatility, complex and interrelated correlation risks, and potential for errors.
What is a Cross rate?
A cross rate is a foreign exchange rate between two currencies quoted against a third common currency, usually the US dollar, rather than being quoted directly against each other. Cross rates allow traders and investors to determine the value of one currency relative to another when a direct exchange rate is unavailable.
Cross rates do not necessarily need to use the USD. However, historically, the USD has often served as a common intermediary currency due to liquidity and stability, dominance in global trade, central bank reserves, and Forex market structure. The USD is one of the most liquid and stable currencies globally, with most international transactions conducted in USD, thus establishing it as a reliable intermediary. The dominance of the USD in global trade further reinforces this role, as the USD is the primary currency used for pricing many commodities, including oil, gold, and other significant goods. Consequently, its extensive use in trade makes it a natural choice for cross rates. The USD constitutes a significant portion of foreign exchange reserves held by central banks worldwide, supporting its intermediary role. The structure of the foreign exchange (Forex) market facilitates trades through the USD, as many currency pairs are quoted against it, simplifying the process of calculating cross rates.
Cross rates are inherent to the forex market, which deals with cross-country currency pairs. EUR/GBP (Euro/British Pound), EUR/JPY (Euro/Japanese Yen), CHF/JPY (Swiss Franc/Japanese Yen), and AUD/NZD (Australian Dollar/New Zealand Dollar) are examples of cross rates.
Cross rate transactions involve converting one currency for its equivalent value in USD, the base currency, and then exchanging the USD for the second currency. The base currency does not have to be the US dollar and always has a value of 1.
Cross rates between currencies are usually calculated electronically in most exchanges, but understanding the calculations is essential for potential market players as they learn forex trading.
Are Cross rate and Cross currency the same thing?
No, cross rates and cross currencies are not the same thing. A cross rate, or currency triangulation, determines an exchange rate between two currencies using a third currency, typically the USD. Cross currency, on the other hand, refers to any currency pair or transaction that does not include the USD.
Traders using cross rates must convert their money into US dollars before converting it to their desired currency. Traders and investors using cross currencies like EUR/JPY or AUD/CAD get their exchange rates quoted directly in the forex market without referencing the USD.
What is the Importance of Cross Rate in Forex Trading?
The importance of cross rates in forex trading lies in their ability to facilitate direct currency exchange between non-USD pairs. Cross rates enable traders to exploit trading opportunities in minor and exotic currency pairs beyond the major forex pairs involving the USD.
Traders who understand cross rates can easily identify arbitrage opportunities in the market and profit from the discrepancies between different currency pairs’ prices. Investors and long-term traders use cross rates to hedge their positions and limit their exposure without involving the USD. Cross rates are helpful for businesses operating in multiple countries or investors with portfolios denominated in different currencies.
Cross rates enhance risk management in FX trading by enabling traders to diversify their portfolios beyond USD-centric pairs. Purchasing cross currencies reduces a portfolio’s exposure to US dollar fluctuations and allows traders to develop custom strategies for trading multiple currencies.
Cross rates eliminate the double conversion problem where traders first convert one currency to USD and then convert USD to the intended currency, reducing transaction costs and slippage from trades.
How does Cross Rate Work?
A cross rate works by determining the exchange rate between two currencies that do not have a direct market quote (excluding the US dollar) using their exchange rates with a third currency like the USD. Cross rates aim to generate correct cross-pair quotes by calculating their exchange rate against an international currency such as the US dollar.
Cross rates’ foundation comes from how two currencies are quoted against each other, where each pair has a base currency and a quote currency. For example, in AUD/JPY, AUD is the base currency, and JPY is the quote currency.
Cross rates introduce a third currency. The base and quote currencies are quoted against the US dollar exchange rate. Traders looking to buy the AUD/JPY will sell their Japanese yen by converting them into USD, then buy Australian dollars with the dollars received.
Markets rely on technology like electronic trading platforms to aggregate quotes from liquidity providers and provide real-time market data feeds to traders. Other technologies like cloud-based solutions, advanced order types, and algorithmic trading help to streamline the entire cross rate process.
Cross rate transactions in the past were handled by intermediaries at USD exchange booths, but nowadays, most trading platforms bypass the booths by automatically calculating cross rates.
How to Calculate Cross Rate?
Calculating a cross-exchange rate using a cross-rate formula is listed below.
- Identify two currencies for the cross rate: Choose any currency pair that does not involve the US dollar, e.g., EUR/GBP.
- Find their exchange rates against USD: Obtain the direct exchange rates of the first currency (EUR) and the second currency (GBP) against a common currency (usually the USD).
- Calculate the cross exchange rate: Divide the exchange rate of Currency X (EUR) to USD by the exchange rate of Currency Y (GBP) to USD. The formula for this is Cross rate (X/Y) = Exchange Rate (Y/Common Currency) / Exchange Rate (X/Common Currency), or Cross rate (EUR/GBP) = EUR/USD ÷ GBP/USD.
- Adjust the formula for pairs with forward and reverse quotes, e.g., AUD/JPY: Change the calculation method from division to multiplication. Specifically, multiply the exchange rate of Currency A (AUD) to USD by the exchange rate of Currency B (JPY) to USD. The cross rate (X/Y) can be calculated as follows: Cross rate (X/Y) = Exchange Rate (Y/Common Currency) * Exchange Rate (X/Common Currency). For example, the cross rate for AUD/JPY would be calculated as AUD/USD * USD/JPY.
How does cross-rate calculation change between direct quotation vs indirect quotation?
Calculating cross rates with direct quotation involves straightforward calculation, while indirect quotation may require currency conversion before the cross rate calculation.
In a direct quotation, the exchange rate is expressed as domestic currency units per foreign currency. For example, in the USD/JPY exchange rate, the quote shows how many Japanese Yen one US Dollar is worth. The cross-rate calculation involves finding the exchange rate of two foreign currencies by dividing or multiplying their respective direct quotes against a common domestic currency. For instance, if you have direct quotes of EUR/USD and USD/JPY, you calculate the EUR/JPY rate by multiplying EUR/USD by USD/JPY.
In an indirect quotation, the exchange rate is expressed as foreign currency units per domestic currency. For instance, the USD/GBP exchange rate shows how many British Pounds one US Dollar can buy. The cross-rate calculation requires finding the reciprocal of the indirect quotes, if necessary, and then applying division or multiplication similar to the direct method. For example, to find the EUR/JPY rate, you convert the indirect quotes to their reciprocals if needed and then multiply or divide accordingly.
How to use Cross rate?
To use cross rate effectively, identify a currency pair and determine the exchange rate of its constituent currencies against the dollar.
Secondly, calculate the cross rate by dividing the exchange rate of the base currency to the USD by the exchange rate of the quote currency to the USD. The result is the cross rate that shows how much of the quote currency is needed to buy one unit of the base currency.
Thirdly, use the cross rate value to execute direct currency conversions or trade exotic currencies to diversify the trading portfolio.
Finally, exploit up-to-date and accurate exchange rates provided for free by most forex brokers to avoid losing money due to miscalculation.
How is Cross rate utilized in Forex Brokers?
Forex brokers utilize currency cross rates to enable traders to calculate the exchange rate for exotic currency pairs that do not involve US dollars. Forex brokers use cross rates to expand the range of currency pairs offered and to alert traders when arbitrage opportunities occur in the forex market. Forex broker platforms provide tools that enable traders to chart cross rates, apply technical indicators, and analyze historical data.
Forex trading platforms connect a wider pool of buyers and sellers, increasing market liquidity for unpopular cross-rate pairs and ensuring traders get better exchange rates for their positions.
Cross rates help forex brokers and traders react to the impact of economic events and policy changes on different currency pairs. Understanding these impacts helps the broker provide the cross currencies and trading tools traders need. The top forex brokers offer traders accurate cross rate quotes to enable them to hedge positions effectively.
Some cross rate traders use algorithmic trading to monitor quotes across different currency pairs at high speeds and execute trades automatically, increasing the speed and efficiency of cross rate transactions.
What are Examples of Popular Cross rates in Forex Trading?
There are four popular examples of cross rates in forex trading. These are EUR/JPY, AUD/NZD, EUR/GBP, and EUR/SEK. The examples of popular cross rates in forex trading are listed below.
1. EUR/JPY
The Euro/Japanese Yen FX cross rate is popular because the EUR and JPY are major global currencies. EUR/JPY cross rate offers many opportunities for traders during the Asian-London sessions overlap.
The formula to calculate the EUR/JPY cross rate is EUR/JPY = EUR/USD x USD/JPY.
As of 28th May 2024, EUR/JPY = 170.6280, EUR/USD = 1.0861, and USD/JPY = 157.1540. The cross rate (EUR/JPY) = 1.0861 * 157.1540 = 170.6850. The difference of 0.57 is caused by the bid-ask spread in the market.
2. AUD/NZD
The Australian Dollar/New Zealand Dollar FX cross rate is a minor cross rate that offers the most trading opportunities during the Asian trading sessions.
The formula to calculate the AUD/NZD cross rate is AUD/NZD = AUD/USD ÷ NZD/USD.
As of 28th May 2024, AUD/NZD = 1.0826, AUD/USD = 0.6650, and NZD/USD = 0.6143. The cross rate (AUD/NZD) = 0.6650 ÷ 0.6143 = 1.0823. The difference of 0.0003 is caused by the bid-ask spread in the market.
3. EUR/GBP
The Euro/UK Pound Sterling FX cross rate is a major cross rate that reflects the economic conditions between the Eurozone and the United Kingdom.
The formula to calculate the EUR/GBP cross rate is EUR/GBP = EUR/USD ÷ GBP/USD.
As of 28th May 2024, EUR/GBP = 0.8508, EUR/USD = 1.0860, and GBP/USD = 1.2761. The cross rate (EUR/GBP) = 1.0860 ÷ 1.2761 = 0.8511. The difference of 0.0003 is caused by the bid-ask spread in the market.
4. EUR/SEK
The Euro/Swedish Krona FX cross rate is an exotic cross rate that indicates the economic conditions between the Eurozone and Sweden.
The formula to calculate the EUR/SEK cross rate is EUR/SEK = EUR/USD ÷ SEK/USD.
As of 28th May 2024, EUR/SEK = 11.4768, EUR/USD = 1.0860, and SEK/USD = 0.0943. The cross rate (EUR/SEK) = 1.0860 ÷ 0.0943 = 11.5164. The difference of 0.0396 is caused by the bid-ask spread in the market.
What are the Benefits of Using Cross Rates?
The benefits of using cross rate are listed below.
- Diversification: Cross trades allow forex traders to diversify their portfolios across multiple currency pairs, reducing their dollar dependence and spreading their overall risk.
- Enhanced trading opportunities: Cross rates open up opportunities to trade minor and exotic currencies from different regions, such as EUR/JPY, GBP/CHF, AUD/NZD, and EUR/TRY.
- Flexibility: Cross rates allow forex traders to trade non-USD currency pairs with high volatility, like GBP/JPY, and change strategies when market conditions change.
- Risk management: Cross rates enable traders and businesses to assess their exposure to currency fluctuations and hedge their positions without relying solely on the US dollar.
- Arbitrage opportunities: Cross trades enable traders to profit from price discrepancies between the direct market quotes and the calculated cross rates using strategies like triangular arbitrage.
What are the Drawbacks of using Cross rates?
The drawbacks of using cross rate are listed below.
- Liquidity risk: Cross rates often have lower trading volume than major forex pairs, resulting in wider spreads and difficulty in executing large trades at the desired prices.
- Limited availability: Currency combinations that are less accessible may not be actively quoted by most brokers, forcing traders to calculate them using the existing USD quotes. Manually calculating cross rates may introduce inaccuracies due to rounding errors.
- Increased complexity: Cross rates calculation involves understanding and using the exchange rates of two currencies against a third currency, which is challenging for beginner traders.
- Higher volatility: Cross-currency pairs are usually more volatile and risky for traders than most USD-centric major pairs due to their low liquidity and large price fluctuations.
- Currency correlation: Cross rates may be influenced by the same factors affecting their constituent currencies and their relationship with the USD, leading to correlated movements and reducing diversification benefits.
Can Cross rate and Reciprocal Currency be used together?
Yes, cross rate and reciprocal currency can be used together. A reciprocal currency is a forex currency pair that involves the US dollar as the quote currency and not the base currency, e.g., EUR/USD, GBP/USD, and AUD/USD. Reciprocal currencies show how many units of the quote currency (USD) are needed to purchase one unit of the base currency. Cross rates, on the other hand, define the exchange rate between two currencies without directly involving the US dollar as the base or quote currency but instead use the USD as an intermediary.
A reciprocal currency can be used to calculate cross rates when the direct rates are unavailable, as the reciprocal currency definition explains. For instance, most brokers do not quote USD/GBP, so the reciprocal currency GBP/USD performs the cross rates.
What is the difference between Cross rate and Exchange Rate?
The difference between cross rate and exchange rate lies in the currencies involved and their use in trading. Exchange rates and cross rates compare the value of two currencies to determine how many units of one currency can be exchanged for another.
The exchange rate uses all currencies, including USD currency pairs, and it is always quoted in the forex market. Cross rates focus on non-USD currency pairs and are calculated using the exchange rates of the involved currencies relative to a common third currency (usually the USD)