Currency crosses or cross rates may be terms you are unfamiliar with, but they simply refer to a transaction between two currencies, of which the US Dollar (USD) is not one. This means the USD is not used as an intermediary, and one currency is simply exchanged for the other. Naturally, the most commonly used currency crosses involve the world’s other most widely traded currencies, such as the Japanese Yen and the Euro.
- History of Currency Exchange
- Most Commonly Used Currency Crosses
- How Currency Crosses are Calculated
- Advantages of Currency Crosses
- How Traders Can Use Currency Crosses
- Takeaways
History of Currency Exchange
Until the middle of the 20th Century, most currency exchanges would be performed by first converting the currency into USD and then converting the USD into the desired currency. Historically this stems from the strength and confidence in the USD formed decades ago, especially after World War 2, where many currencies were quoted against and even pegged to the USD. The US economy was the strongest during this time period, and the currency was fixed to gold, giving people confidence in it.
The USD remains the world’s reserve currency to this day, with over 80% of forex market transactions involving the USD. This dominance remains despite the massive increase in world trade, as most agricultural goods and commodities are still priced in USD, such as oil. This means many countries that import large quantities of these goods, such as China and Australia, hold large reserves of USD in order to quickly and efficiently purchase what they need.
Although the USDs continued strength and dominance, the rise of the forex market has made it more accessible and efficient for cross-currency pairs to exist. This has led to the rise of some pairs we will look into further such as the GBP/JPY cross, making it easier to convert directly between these currencies and potentially increasing trade between the two.
Most Commonly Used Currency Crosses
Some of the most used currency crosses are, of course, the most traded and most abundant currencies, with common examples being the EUR/GBP, GBP/JPY, EUR/JPY and EUR/CHF. Only the former two are in the world’s ten most traded currency pairs, all the rest involving the USD, showing it has maintained dominance in financial markets.
How Currency Crosses are Calculated
Currency crosses are now generally established as their own exchange rate, but if we did not have this rate, we could calculate it fairly accurately with the method below.
When calculating what a currency cross should be valued at, we must first establish which currency is going to be our base rate, so set to equal one. For all currency crosses in which the Euro is involved, it becomes the base rate, if the GBP is involved and the Euro is not, GBP is instead established as the base rate.
Once the currency we will use for the base rate is set, you must then find each currency’s exchange rate against the USD, with these rates being referred to as the legs of our currency cross. We must make sure we are using the bid (buying price) or ask (selling price) for both exchange rates, and for simplicity, we can make sure our first currency (GBP) is the base rate in its exchange vs the USD and in the second exchange the USD is the base rate. If this is the case, we simply multiply the bid/ask price of the two legs and get the price of the currency cross.
Example: Calculate GBP/JPY
GBP/USD: 1.15 (bid)
USD/JPY: 144.21 (bid)
GBP/JPY: 1.15 * 144.21 = 165.84 (bid)
Advantages of Currency Crosses
As we have seen, currency crosses have become more prevalent as the forex market and trade have expanded into the end of the 20th Century. These direct exchanges provide multiple advantages for individuals, companies, and traders, which we will now look into. Naturally, currency crosses make it easier to make international transactions as there are fewer steps to go through and fewer currencies to deal with, with this also making the transaction cheaper as it then involves only crossing one spread. This benefit is furthered by the fact currency crosses have become much more frequently used for exchanges, meaning the spreads have narrowed, especially for the major currency crosses. This has occurred due to the demand for the currency cross increasing, decreasing the cost of international transactions further. This decreased cost can be seen clearly in our basic calculation above, where we established the GBP/JPY cross was 165.84 when calculating through the USD, but the actual GBP/JPY at the time of writing is 165.34. This seemingly small gap can make a huge difference when large sums are being converted.
How Traders Can Use Currency Crosses
Currency crossers can be used in multiple ways by traders in order to try and gain an edge and make profits. One-way traders may use a currency cross is to bet on world events, with an easy example being Brexit. The trader could set up a position in either direction by using the EUR/GBP, this would be less capital intensive, less complex and less expensive than using both the EUR/USD/ and GBP/USD to set up your position. Furthermore, the trader may want to use a currency cross in order to take up a position on a certain currency while removing the presence of the USD if they think it may also be impacted. Another reason for traders to use currency crosses as it gives them more options in how and what they trade. This can be seen by looking at the majors and the commodity currencies, all of which involve an exchange that involves the USD. Trading just these, which many traders do, not only restricts them to only seven exchanges to trade but also means a vast majority of their trade speculation depends on if the dollar is weak or strong on the day. Trading cross currencies eliminates this anti/pro USD restriction and opens up a vast array of other less popular currencies to trade.
Currency Crosses Takeaways
You should now understand what currency crosses are, why they are a popular form of trading and why you should consider trading Forex Crosses with Hantec Markets.
