What are Cross Currency Pairs?
The US Dollar is the most owned currency in the world. So in a way, it makes sense that a majority of currency trading takes place in relation to the US dollar. However, some forex transactions may happen between other currencies. When the US dollar is not involved in currency trade, it is called a cross-currency pair.
Understanding currency pairs
The forex market or foreign exchange market is where currency trading happens. One currency may be traded out for another currency by a big bank, corporation, forex traders or institutional investor. Converting one country’s currency to another result in currency pairs. For instance, let’s assume you want to convert the Euro to US Dollars. This currency pair is represented as EUR/USD.
The first currency is the base or transaction currency. The second currency is called the quote currency. In the EUR/USD currency pair, EUR is the base currency, and USD is the quote currency. When writing this article, the EUR/USD quotes was at 1.0967. That means that 1 EUR is worth 1.0967 USD or you need to pay 1.0967 USD to buy 1 Euro.
Additional Read: A comprehensive guide to Currency Market
The emergence of cross currency
After World War II, growing international trade necessitated a forex market where currencies could be exchanged. Since the US economy emerged as the strongest globally, naturally, most currencies were exchanged in terms of the US dollar. However, as globalisation proliferated and trade among different countries began expanding, there was a need to exchange other currencies.
Initially, any currency trade required the US Dollar as an intermediary. If the Euro had to be exchanged for Japanese Yen, the trader would first have to exchange Euro for US Dollars and then use the US dollars to purchase Japanese Yen, thus requiring two transactions.
However, in light of the rapidly expanding forex market in recent years, cross-currency pairs have emerged. That is where currencies can be exchanged directly without involving the US Dollar.
Calculating cross currency pair rates
Although the US dollar is not directly involved in cross-currency pair transactions, it is still used to calculate cross currency pair rates. That’s because the US Dollar is the most traded currency globally. Let’s understand the calculation of cross-currency pair rates with an example.
Say you want to exchange the Pound Sterling for the Japanese Yen. This cross-currency pair would be represented as GBP/JPY. GBP is the base currency, and JPY is the quote currency. To arrive at the rate for this cross currency pair, you would first need the GBP/USD quotes. Then you would need the USD/JPY quotes. You will arrive at the GBP/JPY cross currency pair rate by multiplying the two.
Additional Read: Benefits of Forex and Currency Trading
Currency trading is a vital component of financial markets, used for various purposes such as hedging, speculation and diversification. While the US Dollar was an essential part of all currency pairs, given its gold standard, globalisation led to abolishing the gold standard and, consequently, the need for US Dollars to calculate currency pairs. Cross-currency pairs allow seamless currency trading without relying on the US Dollar.
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