All you need to know about cross rates!
Generally, when a person starts trading in currency, they focus on the US Dollar as it is the most owned currency in the world. However, there are many other currencies and pairs of currencies that you can trade in India. Some of these currencies are the Euro, the Japanese Yen, and the Pound Sterling. Now, the bigger question is how the rate for pair of currencies that do not involve USD is determined. Here comes the Cross Rate but before we understand what it is, let’s learn what a cross-currency pair is.
What is a cross-currency pair?
Trading between two currencies happens in the foreign exchange market where one currency is weighed by putting it in pair with another currency. Any currency pair that doesn’t involve the dollar is considered a cross-currency pair, also known as currency crosses. The most popular currencies traded are Euro, US Dollar, Japanese Yen, American Dollar, Pound Sterling, New Zealand Dollar, and Canadian Dollar. So, when you trade any of these currencies with one another excluding the US Dollar from the list, you would be trading cross-currency pairs.
What is a Cross Rate?
Now that you have learned what a cross-currency pair is, let’s return to the Cross Rate. It is the exchange rate between two currencies that are then valued against a third currency. Usually, the third currency in the said definition is the US Dollar. Cross Rate is used to calculate the exchange rate of the currency pairs whose value is generally not quoted. Some of the examples of cross-pairs for which cross rate is calculated – EUR/GBP, AUD/NZD, and CHF/JPY.
Basics of currency pairing trading
To understand how to calculate cross rates, you first need to know everything about the currency pairs in the foreign exchange market. Let’s start with base currency and quote currency. Every currency pair consists of two currencies – the base currency is the one on the left, and the one on the right is the quote currency. Generally, the Euro (EUR) or the British Pound (GBP) is always the base currency in every pair it is a part of. However, if EUR and GBP are paired, EUR will be the base currency, not the GBP. Please find below the entire list of a full order of priorities for the base currency (in regard to major and minor currencies).
- Euro (EUR)
- British/UK Pound (GBP)
- Australian Dollar (AUD)
- New Zealand Dollar (NZD)
- US Dollar (USD)
- Canadian Dollar (CAD)
- Swiss Franc (CHF)
- Japanese Yen (JPY)
Apart from the above information, you should know that currency contracts are often cynical, and even if they occur in foreign currencies on the NSE while trading, the settlement will take place in Indian Rupees.
How to derive a cross exchange rate?
As mentioned earlier, a Cross Rate is the exchange rate between two currencies valued against the third. Two transactions take place in this process. How? When you trade a cross-currency pair, your first transaction would be selling one currency for USD. Once the USD is received, you will use it to buy another currency, making it your second transaction. Clarity about these two types of transactions will help you to understand the derivation of cross exchange rate or Cross Rate.
Let us now understand how to calculate currency cross rate.
- Find the home currency and the foreign currency against which you want to exchange it.
- Figure out the type of quote for both currencies in a pair. Below-mentioned are two types of quotes:
- Direct Quote – When the price of one unit of foreign currency is expressed in the domestic currency (Direct quote = 1 foreign currency unit = X home currency units)
- Indirect Quote – When the price of one unit of domestic currency is expressed in the foreign currency (Indirect quote = 1 home currency unit = X foreign currency units)
- Now use either of the 3 methods based on the type of quotes to derive the Cross Rate.
a. Direct Quote & Direct Quote
To calculate the Cross Rate, divide the quote currency by the base currency on the opposite side. The below table will help you derive the rate for a cross-currency pair, say, JPY/AUD.
|Bid Price||Ask Price||Bid Rate (Rate at which JPY can be bought and AUD can be sold)||Ask Rate (Rate at which the JPY can be sold and AUD can be bought)|
|USD/JPY||116.15||116.35||1.05/116.35 = 0.0090||1.18/116.15 = 0.0101|
b. Direct Quote & Indirect Quote
Calculate the Cross Rate by multiplying the quote currency with the base currency on the same side. The below table will help you derive the rate for a cross-currency pair, say, EUR/AUD.
|Bid Price||Ask Price||Bid Rate (Rate at which EUR can be bought and AUD can be sold)||Ask Rate (Rate at which the EUR can be sold and AUD can be bought)|
|1.29*1.18 = 1.5222|
c. Indirect Quote & Indirect Quote
Divide the base currency by the quote currency on the opposite side to derive the Cross Rate. The below table will help you derive the rate for a cross-currency pair, say, GBP/EUR
|Bid Price||Ask Price||Bid Rate (Rate at which GBP can be bought and EUR can be sold)||Ask Rate (Rate at which the GBP can be sold and EUR can be bought)|
|GBP/USD||2.26||2.35||2.26/1.21 = 1.8678||2.35/1.17 = 2.0085|
With the rapid increase in global trading, cross-currency transactions have become a part of everyday life. Thus, having basic knowledge about them and how they are calculated is a must. With the help of this article, you must have learned that any pair of currencies that doesn’t involve a Dollar is known as cross-currency and Cross Rate is the exchange rate between the two currencies that are valued against a third currency. Additionally, you learned the basics of currency pairing trading and the method to calculate the currency Cross Rate.