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What Is Cross Currency?

02 Nov 2021 0 COMMENT

 The United States of America is the world’s largest economy. It is a $23-trillion economy (2021). The strength of the US economy supports the value of the dollar and that’s why the greenback is the most powerful currency in the world.

In the foreign exchange market, the dollar dominates. Around 90% of forex trading involves the US dollar, though it is only one of the world's 185 currencies.

Cross currency refers to a pair of currencies which does not involve the US dollar.

Dollar dominance

To understand what cross currency is, we need to turn back the clock to the end of World War II. The war had drained a lot of countries monetarily and physically, but a few nations prospered more than ever.

The strongest economy to emerge, in the post-world war era, was the United States. The end of world war also gave way to international trading between world economies. A need was felt to have a common yardstick currency against which all currencies could be pegged to ensure price parity.

The most stable currency at that point was the US dollar. It was decided that to convert any currency against another, it had to be mandatorily converted to the dollar.

Emergence of Cross Currency

With globalisation and rising trading volumes between different nations, a rise in the demand for foreign currencies was seen. Before the functionality of cross-currency trading emerged, the buying and selling of foreign commodities required two transactions:

  • First, converting the buying nation’s own currency into US dollars
  • And second, converting those US dollars into the selling nation’s currency

To facilitate effective trading and give a boost to investors involved in cross-currency trading, the need to convert to US dollars was done away with. Now, if you are an investor, you can directly invest in a cross-currency pair which doesn’t involve the US dollar at all.

Foreign Exchange Market

The best place to see the prominence of cross currency or cross-currency trading is in the foreign exchange market. The foreign exchange market is a culmination of investors, banks, investment management companies and brokers who enable the selling and buying of different currencies.

  • Demand of Cross Currency: No nation, in today’s times, can operate in exclusivity without having any trade ties with the different nations of the world. It’s the era of globalisation and the entire world has become one global village. The prime demand for cross-currency transactions exists because different countries want to make use of the goods and services offered by the other.
  • Supply of Cross Currency: For a country like India, cross currency transactions are not a new development. As per a survey, in 2020, India’s top exports have been diamonds and refined petroleum. Foreign currency flows in from different economies of the world, leading to a significant supply of cross-currency transactions

Cross-currency Pairs

There are several instances wherein cross- currency pairs can prove beneficial:

  • Diversification: Legendary investor Warren Buffet lives by the rule of diversification. To make most profits off from your portfolio, it is crucial to invest in different financial instruments. Currencies, make an exchange investment choice, which can enable increasing your profit margin with cross currency trading. However, it would require close monitoring of the currency price trends and the political, socio economic reasons dictating these movements.
  • Hedging: Hedging, in the context of investments, is basically a position whereby you would like to offset potential losses by one investment through the potential profits from the other. Investing in different cross-currency pairs makes for a good choice to hedge against the volatility of the cross-currency rates and optimises the return on investment.
  • Forex Trade and Speculation: In forex trade, cross currency pairs are excellent facilitators of increasing the trade volumes. For example, with Brexit, there were options to position trades from across the world on the currency pair of EUR/GBP directly. However, if we were to exclude cross-currency pairs, the trade had to be set up separately on USD/GBP and then USD/EUR

 

Conclusion:

Cross-currency pairs are an excellent avenue to explore for those involved in forex trades. It enables setting trade positions in exotic, unlikely pairs which have not been very extensively traded in the past and make profits.

URLs Used for Research

Cross Currency Transaction - Overview, Uses, Role in Arbitrage (corporatefinanceinstitute.com)
Cross Currency - What are Cross Currency Pairs | Angel Broking

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