A cross rate denotes a currency exchange deal involving two currencies, both assessed against a third currency. Typically, the U.S. dollar (USD) serves as the benchmark in foreign exchange markets to determine the exchange rates between the currency pairs.
In this setup, the U.S. dollar always maintains a fixed value of one as the base currency. However, certain currency pairs are reciprocal, meaning the dollar doesn’t act as the base currency.
Trading in a cross-currency pair entails two distinct transactions. Initially, the trader swaps one currency for its equivalent value in U.S. dollars. Subsequently, the obtained U.S. dollars are then exchanged for another currency.
Understanding the Cross Rate
Typically, the U.S. dollar serves as the reference point to ascertain the value of currencies being exchanged. To calculate the cross rate between the British pound and the euro, for instance, you’d initially establish that the British pound is valued at approximately 1.25 to one U.S. dollar, and the euro stands at 1.07 to one U.S. dollar.
The Major Currency Pair
In foreign exchange (forex) trading, the term “cross rate” denotes price quotations involving currencies other than the U.S. dollar. The majority of forex transactions revolve around major currency pairs. For instance, if one of the currencies involved in the exchange is the U.S. dollar, a quoted rate of 1.28 for USD/CAD on a financial news site would signify that one U.S. dollar equals 1.28 Canadian dollars.
The euro-Japanese yen exchange rate is often cited as a typical cross rate since it excludes the U.S. dollar from the equation. However, strictly speaking, a cross rate is defined as such when mentioned by individuals outside Japan or regions adopting the euro as their official currency.
In essence, a cross rate is characterized by its mention in a location where neither currency is prevalent. Nonetheless, the term is commonly employed to denote a trade or quotation devoid of the U.S. dollar.
Examples of Major Cross Rates
Cross-currency pairs offer diverse trading opportunities, with the euro against the British pound (EUR/GBP) and the euro against the Japanese yen (EUR/JPY) emerging as the most actively traded combinations. These two pairs notably secure positions within the top 10 most traded currency pairs.
In a currency pair, the euro serves as the base currency when paired with either the British pound or the Japanese yen. Conversely, if the British pound is included in the pair while the euro is not, the pound acts as the base currency.
Examples of Minor Cross Rates
Less active cross rates traded in the interbank market encompass pairs like the Swiss franc versus the Japanese yen (CHF/JPY) and the British pound versus the Swiss franc (GBP/CHF).
Pairs involving the Japanese yen typically present the yen as the base currency, irrespective of the counterpart currency.
When dealing with cross rates involving currencies of similar value and quoting conventions, it’s crucial to post them accurately to avoid trading errors. For instance, in late December 2023, the New Zealand dollar (NZD) was quoted at 1.08 per Australian dollar (AUD), both against the U.S. dollar. This value indicates the amount of U.S. dollars needed to purchase the respective foreign currency.
However, the quote itself doesn’t specify the base currency. Market convention dictates using the stronger AUD, considering its larger economy, as the base currency. Despite trading near parity, there exists the potential for misquotation.
What Is Reciprocal Currency?
Reciprocal currency refers to a concept within the foreign exchange market where a currency pair involves the U.S. dollar. However, in this scenario, the U.S. dollar isn’t the primary currency for the transaction, nor is it the currency initially quoted.
The main cross currency pairs typically feature bid-offer spreads that are a bit broader compared to the major dollar-based pairs. However, they remain actively quoted in the interbank market. On the other hand, spreads in minor cross pairs are generally wider. Some of them are not directly quoted at all, necessitating the construction of a quote from the bids and offers in the component currencies against the U.S. dollar.
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