What is a Cross Currency?

A cross currency refers to a forex transaction between two different currencies where a third currency, typically the US dollar (USD), is not involved. Traditionally, in foreign exchange transactions, the US dollar serves as the third currency. 

However, in cross currency transactions, such as with the EUR/JPY currency pair, the US dollar is bypassed, and the trade occurs directly between the two different currencies.

Cross currency pairs offer traders the opportunity to engage in trades between different currencies without directly involving the US dollar. These pairs are especially important in global trade and play a role in currency-based investment strategies.

In this article, you will find detailed information about cross currency transactions.

What is a Currency Pair?

A currency pair is a financial instrument that shows the value of one currency against another. When trading in the Forex market, two different currencies are always considered together. One is referred to as the base currency, and the other as the quote (or counter) currency.

For example, the EUR/USD currency pair shows how many US dollars one Euro is worth. If you are trading the EUR/USD pair, the Euro is the base currency, while the US dollar is the quote currency.

How are Cross Currency Transactions Used?

A cross currency refers to foreign exchange transactions conducted between two different currencies without involving a third currency, such as the US Dollar. For example, a Japanese company operating in Europe may engage in foreign exchange between the Japanese Yen (JPY) and the Euro (EUR) directly, without using the US Dollar (USD).

In the Forex market, these transactions allow traders to trade between two currencies without the need for a global reserve currency like the US Dollar. For instance, in the EUR/GBP currency pair, traders can directly trade between the Euro and the British Pound.

Cross currency transactions enable investors to compare the performance of various currencies and profit from these differences. Traders can develop strategies based on the economic conditions of different countries. This method minimizes the influence of the US Dollar in foreign exchange markets and allows for a broader trading pool.

Examples of Common Cross Currency Pairs?

There are various cross currency pairs frequently traded in the Forex market. Some of the most common cross currency pairs are:

• EUR/GBP: Between the Euro and the British Pound. This pair plays an important role in tracking the economic relations between Europe and the UK.
• EUR/JPY: Between the Euro and the Japanese Yen. It is used to analyze the economic dynamics between Europe and Asia.
• GBP/JPY: Between the British Pound and the Japanese Yen. This pair is highly volatile and is often popular in short-term trades.
• AUD/JPY: Between the Australian Dollar and the Japanese Yen. It is typically favored by traders following commodity trading and Australia’s economy.
• NZD/JPY: Between the New Zealand Dollar and the Japanese Yen. It is associated with New Zealand’s agriculture and commodity export-based economy, and it’s considered important due to Japan being a major trading partner in Asia.

How to Derive Cross Currency Exchange Rate?

To calculate a cross currency exchange rate, you can use the values of two currency pairs. First, you need to know the value of both currencies against the US dollar. For example, if you want to find the cross rate between Euro (EUR) and Japanese Yen (JPY), you need the values of the EUR/USD and USD/JPY pairs.

If the currency pairs are USD-based, you can calculate the cross rate as follows: 

• To find the EUR/JPY cross rate, use the EUR/USD and USD/JPY pairs. The EUR/USD pair shows the value of the Euro against the USD, and the USD/JPY pair shows the value of the US dollar against the Japanese Yen.
• The formula is as follows: EUR/JPY = EUR/USD × USD/JPY

Impacts of Forex Rates on Cross-Currency Transactions

The value of cross-currency pairs reflects the relative value between the two currencies being traded. It means that fluctuations in either currency on the Forex market can impact these transactions. For example, in a trade between the Euro (EUR) and the Japanese Yen (JPY), changes in the value of both the Euro and the Yen against the US Dollar (USD) can lead to significant fluctuations in the cross rate between these two currencies.

In the Forex market, factors such as central bank interest rate decisions, inflation rates, economic growth data, and global economic developments play a key role in determining exchange rates. Therefore, it is clear that these factors are the main drivers influencing cross-currency transactions.

Cross-currency transactions, especially those that do not involve USD, aim to minimize the volatility caused by the US Dollar. However, since the USD is the most widely used global reserve currency, movements in the Dollar can still have an indirect effect on other currency pairs in the Forex market.

Fluctuations in Forex rates directly impact the potential gains or losses in cross-currency transactions. And it can be beneficial for traders to keep an eye on the USD even in trades that do not directly involve it as a third currency.

Cross Currency Trading Strategies

• Trend Following Strategy: In cross-currency pairs, traders can follow long-term trends to capitalize on price movements in a specific direction. Traders can use technical analysis tools to identify the trend's direction and strength.
• Arbitrage Strategy: This strategy aims to capitalize on short-term profits by exploiting price differences in cross-currency pairs across different markets. It requires quickly identifying and acting on momentary price discrepancies.
• Breakout Strategy: Traders enter positions when the price breaks through a specific support or resistance level. This strategy is effective during periods of huge price movements in cross-currency pairs.
• Carry Trade: Investors seek to profit from interest rate differentials by investing in currencies with higher interest rates. Long-term positions can be opened to take advantage of interest rate differences between cross-currency pairs.
• Divergence Strategy: When price movements diverge from technical indicators, this strategy helps predict potential trend reversals. It is particularly effective in volatile cross-currency pairs.

Benefits of Cross Currency Pairs

• Cross currency pairs allow investors to trade directly between different currencies without involving the US dollar.
• They offer opportunities to trade in markets outside of major currency pairs.
• They enable traders to diversify their portfolios across different national economies and currencies.
• They encourage investors to take a more comprehensive look at global economic developments, which strengthens overall trading strategies.

Considerations in Cross Currency Transactions

• Cross currency pairs can have lower liquidity compared to major currency pairs. This can lead to wider spreads and increased transaction costs.
• Volatility can be higher in cross currency pairs. Especially when trading without a reference currency like the USD, price movements can be more difficult to predict.
• The economic conditions, interest rates, inflation rates, and central bank policies of both countries involved have a impact on cross currency exchange rates.
• Using leverage in cross currency transactions can increase potential profits but also increase risks.
• Since cross currency transactions are traded in different regions, it’s important to pay attention to the opening and closing times of the markets involved.

More About Cross Currencies

How to manage currency risk?

One of the primary methods for managing currency risk is hedging. Investing in multiple markets with multiple currency pairs can reduce risk in this regard. Setting fixed stop-loss levels is an effective method for limiting risk. Moreover, by monitoring macroeconomic indicators and central bank policies, traders can be prepared for potential changes in exchange rates.

What are the differences between cross currency pairs and major currency pairs?

Cross currency pairs involve trading between two currencies without using the US dollar, while major currency pairs always include the US dollar. For example, EUR/USD is a major currency pair, whereas EUR/GBP is a cross currency pair. Major currency pairs typically offer higher liquidity and lower spreads, while cross currency pairs may have lower liquidity and wider spreads. Majors tend to be less volatile, whereas cross-currency pairs may experience higher volatility.

What technical indicators should be used to analyze cross currency pairs?

In analyzing cross currency pairs, technical analysis tools are often used. Moving averages are effective for identifying price trends. Momentum indicators like RSI (Relative Strength Index) and the Stochastic Oscillator help identify overbought or oversold conditions. Additionally, volatility measures such as Bollinger Bands can also be appropriate for cross currency pairs.

How to develop long-term investment strategies for cross currency pairs?

When creating long-term investment strategies, traders combine fundamental analysis with technical analysis. Long-term trends can be identified by considering a country’s economic indicators, central bank policies, inflation rates, and growth data. Price support and resistance levels can also be analyzed with technical tools. Additionally, strategies like carry trade can be used for generating long-term profits. Traders optimize their portfolios by closely following global economic developments.

How to identify support and resistance levels in cross currency pairs?

Support and resistance levels represent points where price has historically paused or reversed. These levels are typically determined using technical analysis tools. Traders can draw horizontal lines on the price chart to identify these levels. Fibonacci retracement levels and trendlines are also effective in determining support and resistance. When price breaks these levels, it can signal the start of a new trend.

Which economic data most influence cross currency pairs?

Cross currency pairs are influenced by the economic data of both countries involved. Key economic indicators that directly affect cross-currency pairs include inflation rates, growth data, unemployment rates, and central bank interest rate decisions. Additionally, trade balance, current account deficits, and geopolitical events can influence the value of currency pairs. Traders consider interest rate differentials and economic growth expectations when taking positions.