Forex currencies: Cross rates and their use
A British company making sales in Germany uses cross rates received euros into pounds sterling. The company does not need to convert euros into dollars before converting dollars into pounds. Instead, the UK company can use the EUR/GBP exchange rate to convert euros directly into pounds sterling. Since cross rates by definition do not include the US dollar, the most traded cross rate pairs include the second most commonly used currency, the euro. In April 2016, the most popular cross rate pair was the aforementioned EUR/GBP pair, which accounted for 2% of all trades. Cross rate pairs are also common in other major international currencies, including the yen and Swiss franc.
Other less liquid currencies are often not actively traded, with the exception of the US dollar. For investors interested in trading between these less liquid currencies, two transactions are required - first convert the foreign currency into U.S. dollars, and then convert the U.S. dollar into the desired functional currency.
Unique features of cross rates
Cross rates have a number of unique features. First, an investor interested in cross rates need not be as concerned about the fundamentals of the U.S. economy as an investor trading more traditional pairs.
The second unique feature of cross rates is that they tend to be somewhat less liquid (and less actively traded) than traditional pairs, which carries both advantages and disadvantages for investors. Because cross-currency pairs are less closely watched, investors may have more opportunities to discover a unique perspective on market movements. Investors may also have an easier time finding arbitrage opportunities if they utilize less frequently traded currencies.
Finally, the relative lack of liquidity can lead to higher volatility during periods of volatility. Higher volatility gives investors the opportunity for greater gains (or the possibility of greater losses). A negative consequence of cross rates is that low liquidity can lead to increased bid-ask spreads, and in extreme situations traders may even find it difficult to enter or exit their positions.
Factors affecting cross rates
Because most actively traded cross rates involve major international currencies such as the euro or yen, the factors affecting these relationships are similar to those affecting the relationship between the U.S. dollar and other major international currencies. In particular, the relative differences between countries' economic performance, inflation rates, and interest rates typically determine most market fluctuations between these currencies.
Perhaps the most important factor in the movement of cross rates is not what affects them, but what does not. Cross rates are not directly affected by the direction of the U.S. dollar. When trading traditional pairs such as EUR/USD, USD/JPY or GBP/USD, it can be difficult for traders to differentiate their views on the market. This is because all of these relationships ultimately depend on the strength or weakness of the US dollar.
There are exceptions to this rule, but in general, during a strong uptrend, the US Dollar is likely to appreciate against most other major currencies. When the dollar suffers from systemic weakness, it is likely to depreciate against most currencies. This means that whichever pair traders focus on, the most important factor determining their success will be whether they are bullish or bearish on the U.S. dollar.
Bearish or bullish outlook
However, when trading cross rates, a trader does not need to have a bearish or bullish view of the U.S. dollar. Rather, the movement of this relationship is determined by fundamentals and market trends in the respective economies. These relationships provide an excellent opportunity for investors to diversify their currency trades away from the U.S. dollar.
However, this does not mean that cross currency pairs traders can completely ignore the US. As the most important currency in the world, the evolution of the U.S. dollar can have an impact on all currency markets. These effects can affect even those pairs in which the US dollar is not directly involved. While fluctuations in the U.S. dollar have some impact on world exchange rates, they are not the primary determinant of cross-exchange rate dependence.
Cross rates
When trading one of the major pairs, such as EUR/USD, it is difficult for an investor to get a unified view of market events. This is due to the fact that the pair is so heavily traded in the market that countless investors and traders are constantly expending significant resources on predicting future market movements. However, by focusing on the slightly less popular cross rate, an investor can find more opportunities for contrarian views on the dynamics of the relationship. These views can lead to opportunities for higher returns than those found in more traditional U.S.-dollar pairs.
The opportunity to generate above-average returns by studying and researching cross-currency pairs makes this corner of the currency market potentially attractive to investors. The key is to focus on one or two cross-currency pairs and learn as much as possible about their movements. In this way, investors may have the opportunity to profit from this less-watched sector of the market.
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