Cross currency pair

Cross Currency Pair

A cross currency pair, often referred to simply as a "cross," is a pairing of two currencies that does not include the U.S. dollar (USD). These pairs represent an important segment of the global foreign exchange market, where currencies are traded. While the U.S. dollar is the world's most traded currency and typically acts as the intermediary for most transactions, cross currency pairs allow market participants to exchange two non-USD currencies directly. This reduces the need for two separate transactions (e.g., converting EUR to USD and then USD to JPY) into a single, direct trade, enhancing efficiency in currency trading.

History and Origin

The modern foreign exchange market, including the trading of cross currency pairs, largely evolved following the breakdown of the Bretton Woods system in the early 1970s. Prior to this, many currencies were pegged, either directly or indirectly, to the U.S. dollar, which itself was convertible to gold. The shift away from fixed exchange rates to a more flexible, floating exchange rate system after 1971 created a dynamic environment where currencies could fluctuate against one another based on market forces. This transition facilitated the direct exchange of non-USD currencies, as the intermediary role of the U.S. dollar became less rigid. As global trade and financial integration increased, the demand for direct currency conversion between various economies without involving the U.S. dollar naturally grew, leading to the increased prominence and liquidity of cross currency pairs. The International Monetary Fund (IMF) continues to classify and track different exchange rate regimes adopted by its member countries, reflecting the diverse approaches to currency management in an integrated global economy.³

Key Takeaways

A cross currency pair involves two currencies that do not include the U.S. dollar.
They are derived by implicitly or explicitly using the U.S. dollar as an intermediary, even if the transaction is direct.
Cross currency pairs offer direct conversion, bypassing the need for two separate USD-involved trades.
Their liquidity and spread can vary significantly compared to major currency pairs.
They are frequently used by businesses engaged in international trade and investors diversifying their portfolios.

Formula and Calculation

Cross currency pairs are typically quoted in terms of how many units of the quote currency can be exchanged for one unit of the base currency. While seemingly direct, their rates are often calculated using a common third currency, most frequently the U.S. dollar.

If you have the exchange rates of two currencies against a common third currency (C), say Currency A/Currency C and Currency B/Currency C, the cross rate for Currency A/Currency B can be calculated as:

\text{A/B} = \frac{\text{A/C}}{\text{B/C}}

Where:

A/B represents the cross currency pair rate (e.g., EUR/JPY).
A/C represents the exchange rate of Currency A against the common currency C (e.g., EUR/USD).
B/C represents the exchange rate of Currency B against the common currency C (e.g., JPY/USD, often seen as USD/JPY and inverted for calculation).

Interpreting the Cross Currency Pair

Interpreting a cross currency pair involves understanding the relative strength of the two currencies against each other, without the direct influence of the U.S. dollar's perception. For instance, in the EUR/JPY pair, the number indicates how many Japanese Yen (JPY) can be exchanged for one Euro (EUR). A rising EUR/JPY rate means the Euro is strengthening relative to the Yen, while a falling rate means the Yen is strengthening relative to the Euro.

Traders and investors analyze cross currency pairs to capitalize on specific economic trends or interest rate differential between the two non-USD economies. For example, if interest rates are rising in the Eurozone but falling in Japan, it might incentivize a "carry trade" strategy involving EUR/JPY. However, cross currency pairs can exhibit higher volatility and wider spreads than major pairs due to lower trading volumes for some combinations. Understanding the economic fundamentals and market sentiment of both economies involved in the cross currency pair is crucial for accurate interpretation.

Hypothetical Example

Consider a scenario where an investor wants to exchange Euros (EUR) for Japanese Yen (JPY). Direct quotes for EUR/JPY might not always offer the most competitive rates or might be less liquid. Instead, the transaction can be calculated using the U.S. dollar as an intermediary.

Suppose the current market rates are:

EUR/USD = 1.0850 (meaning 1 Euro buys 1.0850 U.S. dollars)
USD/JPY = 155.20 (meaning 1 U.S. dollar buys 155.20 Japanese Yen)

To find the implied EUR/JPY cross currency pair rate, we can calculate:

\text{EUR/JPY} = \text{EUR/USD} \times \text{USD/JPY}

So,

\text{EUR/JPY} = 1.0850 \times 155.20 = 168.392

This means that 1 Euro would buy approximately 168.392 Japanese Yen. In practice, market makers derive and quote these cross rates for direct trading on the spot market.

Practical Applications

Cross currency pairs are integral to global finance, serving diverse practical applications:

International Trade and Business: Companies conducting business between two non-U.S. dollar countries frequently use cross currency pairs to manage their currency exposures. For instance, a German exporter selling goods to Japan will receive JPY and needs to convert it to EUR. A direct EUR/JPY trade eliminates the need for an intermediate USD conversion, potentially saving on transaction costs and reducing multiple spread payments.
Investment and Portfolio Diversification: Investors looking to diversify their portfolios beyond major currency exposures often turn to cross currency pairs. These pairs can offer unique opportunities based on the specific economic dynamics or geopolitical factors between the two non-USD countries.
Hedging Strategies: Businesses and investors use cross currency pairs to hedge against foreign exchange risk. For example, an investor with a portfolio heavily weighted in Australian dollar (AUD) assets might use an AUD/CAD (Canadian Dollar) cross currency trade to hedge against specific risks related to the Canadian economy without impacting their broader USD exposure.
Arbitrage Opportunities: Due to the triangulation method (using a third currency to calculate the cross rate), minor discrepancies in quoted rates can occasionally lead to arbitrage opportunities. Sophisticated traders with fast execution systems can exploit these brief imbalances to profit.
Economic Analysis: Analysts study the movements of cross currency pairs to understand specific regional economic relationships and capital flows, independent of the U.S. dollar's global influence. For example, the AUD/JPY pair is often watched as a proxy for risk sentiment, given Australia's commodity exports and Japan's low-yield funding currency status. The global foreign exchange market, of which cross currency pairs are a part, is the largest financial market in the world, with daily turnover reaching trillions of U.S. dollars, as detailed by the Bank for International Settlements (BIS) Triennial Central Bank Survey.²

Limitations and Criticisms

While cross currency pairs offer directness and specific trading opportunities, they come with certain limitations and criticisms:

Lower Liquidity: Compared to major currency pairs (e.g., EUR/USD, USD/JPY), many cross currency pairs exhibit lower trading volumes. This can result in wider bid-ask spreads, meaning a higher cost for executing trades, and can make it more challenging to enter or exit large positions without impacting the market price.
Higher Volatility: Due to lower liquidity and the combined influences of two non-USD economies, cross currency pairs can sometimes experience greater price swings. This increased volatility can lead to higher risks for traders and investors if not managed properly.
Complexity of Analysis: Analyzing cross currency pairs requires understanding the economic and political factors influencing two non-U.S. dollar economies, as well as their relationship to each other. This can be more complex than analyzing a major pair that always includes the dominant U.S. dollar. Academic research on currency trading strategies highlights the complexities and various factors that contribute to the profitability, or lack thereof, of different approaches in currency markets.¹
Influence of the U.S. Dollar: Even though the U.S. dollar is not explicitly part of a cross currency pair, its implicit role in global finance means that significant movements in the U.S. dollar or changes in U.S. monetary policy can still indirectly affect cross rates. For example, if the USD strengthens significantly, it might indirectly pull down the value of both currencies in a cross pair if they are also weakening against the dollar.

Cross Currency Pair vs. Major Currency Pair

The primary distinction between a cross currency pair and a major currency pair lies in the involvement of the U.S. dollar.

Cross Currency Pair: These are currency pairs that do not include the U.S. dollar. Examples include EUR/JPY, GBP/AUD, CAD/CHF. They allow for direct exchange between two non-USD currencies, often with the U.S. dollar acting as an implicit intermediary for rate calculation.
Major Currency Pair: These are currency pairs that always include the U.S. dollar. They represent the most frequently traded currency pairs globally due to the U.S. dollar's status as the world's primary reserve currency and its use in most international transactions. Examples include EUR/USD, USD/JPY, GBP/USD, AUD/USD, USD/CAD, USD/CHF, and NZD/USD.

Major currency pairs generally boast higher liquidity and tighter spreads compared to most cross currency pairs, reflecting their dominant trading volumes. Confusion sometimes arises because while a cross currency pair doesn't display the USD, its value is typically derived from the individual rates of each currency against the USD.

FAQs

What are some common examples of cross currency pairs?

Common examples include EUR/JPY (Euro/Japanese Yen), GBP/AUD (British Pound/Australian Dollar), EUR/GBP (Euro/British Pound), CAD/CHF (Canadian Dollar/Swiss Franc), and AUD/NZD (Australian Dollar/New Zealand Dollar).

Why are cross currency pairs important?

Cross currency pairs are important because they facilitate direct trade and investment between countries without needing to convert through the U.S. dollar, potentially reducing transaction costs and simplifying international financial operations. They also offer unique trading and hedging opportunities based on specific economic relationships between non-U.S. dollar economies.

How is the rate of a cross currency pair determined?

The rate of a cross currency pair is determined by market forces of supply and demand, but it is often derived from the individual exchange rates of each currency against a common third currency, most commonly the U.S. dollar. Market makers use these underlying rates to quote the direct cross currency pair.

Are cross currency pairs more volatile than major currency pairs?

Generally, many cross currency pairs can be more volatile than major currency pairs. This is often due to lower liquidity and wider bid-ask spreads compared to the highly traded major pairs, which can amplify price movements.

Can individuals trade cross currency pairs?

Yes, individuals can trade cross currency pairs through various online forex brokers. These brokers provide access to the foreign exchange market, allowing retail traders to speculate on the price movements of different currency pairs, including crosses.