What is Cross Currency?

Cross currency means a currency pair or transaction that does not involve the US dollar. A cross-currency transaction does not use the US dollar as the contract settlement currency. A cross currency pair is one that has a pair of currencies traded in forex that is not inclusive of the US dollar. Common cross currency pairs are inclusive of the Euro and the Yen.

Cross Currency Basis Explained

At the end of the Second World War and at the start of the globalization process, there was a requirement to value countries' currencies in a uniform way. As a result, all countries' currencies were compared to the dollar. 

It was due to the fact that, during WWII, the United States had one of the strongest economies and currencies in the world, and its currency was also connected to gold, forming the 'gold standard.' As a result, each currency developed a cross currency swap with the dollar.

Given the fact that the US dollar is the world's reserve currency - the advent of the forex market has made cross-currency transactions and pairs commonplace. For instance, the GBP/JPY cross was created to help the ones in England and Japan, the ones who wanted to convert their money without first converting it into US dollars.

What is a Cross Currency Pair?

The process of weighing a country's currency by putting it in currency pairs with another currency, most frequently the dollar, produces a currency pair. Take, for instance, the Euro and the US Dollar - which is denoted by the symbol EUR/USD. The base currency is the first of the currency pair, while the second is the quote currency. As a result, the Euro is the base currency, whereas the dollar is the quoted currency. As a result, 1 Euro is equivalent to 1.23 USD.

How are Cross Currency Transactions Used?

Cross currency swaps, which are contracts used to borrow money at a lower rate, are frequently utilized in debt transactions involving different currencies. A currency swap is an agreement between two parties to swap interest payments and principal in different currencies.

When investors desire to hedge against foreign currency swings, cross-currency transactions are also used with foreign currency deposits.

As a result, investors that engage in multi-currency transactions frequently do so in order to mitigate financial risks. Investors may also desire to use cross-currency trades as part of an arbitrage plan to make a profit.

Furthermore, cross-border payments make use of cross-currency transactions. Customers that use banks that accept such transactions have more options for receiving and sending cross-border payments. It also boosts demand for international trade and payments.

How to Derive Cross Exchange Rate?

When you are trying to derive the rate at which you will change your base currency, and it does not involve USD, you would have to find the cross rate. In order to check the cross rate, you will have to find two currency pairs, and they are.

- One that has your home currency.

- The other than contains the foreign currency that you want to exchange it with.

The very next step is to know what type of quote each of the two selected currency pairs is and to apply the corresponding rule for deriving a cross rate.

The direct quote: 1 foreign currency unit = 'x' home currency units.

The indirect quote: 1 home currency unit = 'x' foreign currency units.

Benefits of the Cross Currency Pairs

There are varied benefits to cross currency pairs and transactions, and they are mentioned below:

  • With the end of the gold standard and the rise of worldwide trading at wholesale levels, cross-currency transactions have become a part of our everyday life.
  • Not only do these transactions make it easier for international payments, but they also have made them marketed cheaper.
  • As individuals do not have to swap the currency into US dollars first, there is only one transaction. This means only one spread is crossed.
  • As non-USD pairs are now more commonly traded, the spreads have tightened, making it even cheaper to move from one currency to the other.
  • Cross-currency transactions can be utilized as a part of a profit-generating arbitrage strategy to purchase and sell different currencies. Investors use a tactic known as triangle arbitrage to take advantage of pricing differences between different currencies in the foreign exchange market.



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