19. Currency Crosses
If you are reading this, the assumption is that you are aware of what a currency pair is and you very well understand the basics of Forex market. You also know how a currency pair is quoted. If this assumption is wrong stop here and please go back and refer to the basics of Forex trading. Otherwise, this is going to be like some unknown language to read. Ok, so coming to our topic, historically US Dollar was the basis for currency conversions. For example if someone wanted to convert GBP to AUD, they had to first convert GBP to USD and then to AUD. This is because USD is the reserve currency in the world. Cross currencies bypass this step of converting to US Dollar. With the invention of cross currency, individuals and businesses can directly convert their currency to the desired currency without having to first convert them into US Dollars. So, Cross Currency refers to a pair of currency traded in the Forex Market that does not include the US Dollar as either the base currency or the quote currency.
To calculate the bid and ask prices of a cross currency pair we have to consider the two parts of each pair.
For example to calculate the GBP/AUD bid rate multiply the bids of GBP/USD and USD/AUD. GBP/USD and USD/AUD are also known as the legs of this currency pair.
Another term we would like to introduce you to will be “Majors”. The major currencies in the world when paired with USD such as EUR/USD and GBP/USD are known as Major. However as we just learnt, currency crosses are a bit different as they don’t include the USD.
- EUR/USD– Euro versus U.S. dollar
- GBP/USD– British pound versus the U.S. dollar
- AUD/USD– Australia dollar versus the U.S. dollar
- NZD/USD– New Zealand dollar versus the U.S. dollar
- USD/JPY– U.S. dollar versus the Japanese yen
- USD/CHF– U.S. dollar versus the Swiss franc
- USD/CAD– U.S. dollar versus the Canadian dollar
Examples of Cross Currency pairs:
- EUR/CHF – Euro versus the Swiss franc
- EUR/GBP – Euro versus the British Pound
- EUR/JPY – Euro versus the Japanese yen
- GBP/JPY – British Pound versus the Japanese yen
So, one of the advantages of using currency crosses is that it allows you to buy and sell both the strongest and the weakest currency pairs in the market. Also, when compared to USD based pairs, cross currency pairs are known to make greater market moves. Greater market movements or volatility in turn increases the trading opportunities available.
When currency pairs are based on the US Dollar, the price movement is highly tied to the USD, i.e. majors move identical to each other. Cross currency pairs provides a trader with more options to choose from. Since the cross currencies are not based on the US Dollar, you can expect to see different behaviours for each currency pair. There are lot of cross currency pairs available for you and hence lots of trading opportunities.
Cross currency pairs are less liquid, which means there are less traders entering into cross currency trades. Because of low liquidity, price can trend very well. This means, when there are large moves, they can form a long trend and price may move quickly. Keep in mind that, if price can trend quickly, it can quickly reverse or retrace too. There can be rapid price actions you can see with these currency pairs. Also, while getting into a trend, you would face multiple losses before finally making some money. Spread can also be higher because of illiquidity. So transaction costs are normally higher.
Interest Rate Differentials
Pretty clear from the heading, difference in the interest rates between two currencies in a pair is known as interest rate differential. If one of the currency has an interest rate of 3% and another one in the pair has an interest rate of 2%, interest rate differential for that particular currency pair will be 1%.
There are many cross currency pairs that have high interest rate differentials and hence are key pairs in these types of trading. Thus, with these pairs you can make profit out of the position you take in the market and the interest rate differential on that trade.
Also, if economic conditions are very good and favourable in a country, the value of its currency obviously goes high due to higher demands. If you know that the value is going to go high, you have to then look for a weaker currency to pair with this one so as to make profit. That is where cross currency pairs come in very handy. For example if GBP is doing very good and AUD is a bit weaker.
You go long on the pair GBP/AUD and hence to benefit out of the trade. Now you see how you can make use of opportunity without having to deal with the UD dollar. Do your thorough analysis and match stronger currency to weaker ones.
Now, if you want to trade only majors and don’t want to take position in cross currency pairs, you can still use the currency crosses to decide on the Major currency pairs you want to trade upon. For example, if you wish to choose between AUD/USD and GBP/USD and don’t know how you want to go about it. Cross currency pair AUD/GBP comes to your rescue. If you see that AUD/GBP is going down or is depicting a downtrend, you know that GBP is relatively stronger than AUD. So you have your answer. Go ahead and buy GBP/USD because GBP is doing better than AUD.
Hence, keep in mind that cross currency pairs could give you some idea about the relative strength of currencies in the Forex market.
Please note, trading multiple cross currency pairs might create problems if you are not well versed in the trading strategies. Be prepared to face high spreads with crosses when compared to majors.
Learn with experience and then you will be on top of your stuffs. Finally, being focussed is the key.