What is Cross Rate?| Espresso

What is Cross Rate?

The foreign exchange market, commonly referred to as "forex" or "FX," is dynamic and intricate. To operate in this constantly changing еnvironmеnt, tradеrs must comprehend thе nuances of currеncy еxchangе. Cross exchange rates are a well-known notion, but another equally significant actor in the market is less well-known: the cross rate.

Published on 24 July 2024

Consider yourself an experienced trader in London who closely watches the Japanese Yen (JPY) and the Euro (EUR). But hold on, every currency quote you view uses the US Dollar (USD) as an intermediary. The USD/JPY rate indicates how many Yen you get for every dollar, and the EUR/USD rate indicates how many dollars you need to buy one Euro. However, what if you prefer to exchange euros for Yen without using the dollar? This is where cross-rate magic becomes useful.

 

Understanding Cross Rate

The majority of currency exchange rates in the foreign exchange (forex) market are quoted in US dollars, which is the world's main reserve currency. Cross rates, however, come into play when investors or dealers wish to swap one foreign currency for another without first translating it into US dollars.

The cross exchange rates of the two currencies involved, with the USD serving as an intermediary, are used to calculate cross rates. To find the exchange rate between the Euro (EUR) and the Japanese Yen (JPY), for example, a trader can multiply the EUR/USD rate by the USD/JPY rate to get the EUR/JPY cross rate if only the EUR/USD and USD/JPY rates are available.

 

Significance Of Cross Currency Rate 

The majority of currency cross rates in the foreign exchange (forex) market are quoted in US dollars, which is the world's main reserve currency. Cross rates, however, come into play when investors or dealers wish to swap one foreign currency for another without first translating it into US dollars.

The exchange rates of the two currencies involved, with the USD serving as a middleman, are used to calculate cross rates. To find the exchange rate between the Euro (EUR) and the Japanese Yen (JPY), for example, a trader can multiply the EUR/USD rate by the USD/JPY rate to get the EUR/JPY cross rate if only the EUR/USD and USD/JPY rates are available.

Cross rates improve risk management in FX trading by allowing traders to diversify their portfolios beyond pairs centered around the USD. Investing in cross-currencies enables traders to create unique trading techniques for several currencies while lowering a portfolio's exposure to swings in the US dollar.

Cross rates reduce transaction costs and trade slippage by resolving the double conversion issue, which arises when traders first convert one currency to USD, then the intended currency.

 

Calculating Cross Exchange Rates: Unveil The Mechanics 

If you want to calculate a cross-exchange rate, use the cross-rate formula below:

  • Find the cross rate's two currencies: Select any currency combination, such as EUR/GBP, that does not involve the US dollar.
  • Find their rates of exchange for the US dollar: Find the first currency's (EUR) and second currency's (GBP) direct exchange rates against a common currency (typically the USD).
  • Determine the cross-exchange rate: Currency X's (EUR) to USD exchange rate is divided by Currency Y's (GBP) to USD exchange rate. It can be written as Cross rate (EUR/GBP) = EUR/USD ÷ GBP/USD, or Cross rate (X/Y) = Exchange Rate (Y/Common Currency) / Exchange Rate (X/Common Currency).
  • Modify the formula for pairs with forward and reverse quotations, like AUD/JPY: Switch from division to multiplication as the calculation method. To be more precise, multiply the AUD to USD exchange rate by the JPY to USD exchange rate for Currency B. The given formula can be used to get the cross rate (X/Y): Exchange rate (Y/Common Currency) * Exchange rate (X/Common Currency) equals the cross rate (X/Y). For instance, AUD/USD * USD/JPY is the formula for calculating the cross rate for this pair. 

 

Why Cross Rates Matters: Trader's Advantage

Cross rates are essential in trading and investment. They allow dealers and companies to exchange foreign currencies directly, eliminating the need for local currency. Lower transaction costs and quicker trades are frequently the results of this direct translation.

An intriguing issue is that currency cross rates are significant for currencies traded extensively globally but have a weak relationship with the US dollar. Cross rates focus on pairs like GBP/JPY or EUR/CHF, which creates more trading opportunities than straight quotations, which always involve the USD like EUR/USD or GBP/USD. It draws attention to the dynamics of international trade, which is excellent for people who deal in multiple currencies.

 

Trading With Cross Rates: Strategies And Considerations

Now that you are aware of the fundamentals let's look at some real-world trading uses for currency cross rates:

  • Hedging Techniques: One way to protect against currency swings is to use cross rates. You can decrease possible losses by opening a position in a currency pair that is negatively connected to your primary transaction.
  • Finding Trends: Cross-rate analysis can highlight general market trends over time. For example, a persistent decline in the value of the Euro relative to other currencies could portend a more significant change in the economy.
  • Technical Analysis: Charts and indicators used in technical analysis might incorporate cross rates. This can assist in locating possible trading entry and exit opportunities.

However, keep in mind that cross rates come with their own set of considerations:

  • Market Liquidity: Less liquid cross rates for less frequently traded currencies may result in wider spreads (the gap between the purchase and sell price).
  • Transaction Costs: Although cross rates can lower conversion rates, traders should account for brokerage fees when trading a specific currency pair.
  • Volatility: Cross rates may fluctuate more than quotes based on the US dollar. Therefore, traders must be willing to take on additional risks.

 

The Final Word: Mastering The Currency Maze

Currency cross rates are among the most effective tools in a forex trader's toolbox. You can more confidently negotiate the market's intricacies if you comprehend their mechanics and apply them strategically. Recall that information is power, and in the dynamic realm of foreign exchange, cross rates provide an invaluable perspective for spotting opportunities and making wise trading choices.


Are you prepared to start trading forex? Investigate typical cross rates and practice your calculations beforehand. Explore technical analysis and develop your trading techniques as you gain experience. Recall that discipline, risk management, and in-depth knowledge of the cross rates are necessary for effective trading.

Chandresh Khona
Team Espresso

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