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Cross-rates on the Forex market: an important concept and their role in trading

Cross-rates on the Forex market: an important concept and their role in trading

Table of Contents

  • What is a cross-rate on the Forex market?
  • Why do traders need cross-currency exchange rates?
  • How cross-courses are formed
  • How to calculate cross currency rates
  • Key factors influencing cross-courses
  • Advantages of cross-rate trading
  • Conclusion

The US dollar has been a leader on the world stage for many decades, being the strongest reserve currency. In people's minds, it is also the main monetary unit. How do I see this? When it comes to the local currency rate, everyone understands that this price is exactly to USD. On forex, all currency pairs with the US currency are called the main ones.

However, it is not uncommon for foreign exchange market participants to make a direct transaction with foreign currency units that do not have the dollar in them. For example, they want to buy the Swiss franc (CHF) for the pound sterling (GBP). This is also possible if they use cross currency pairs.

What is a cross-rate on the Forex market?

In fact, on Forex, most currency pairs are cross-country. For example, EUR / JPY (euro to Japanese yen), EUR/CHF (euro to Swiss franc), AUD/JPY (Australian dollar to Japanese Yen), GBP/JPY (pound sterling to Japanese Yen), and so on. Despite the fact that they are less liquid than the main ones, trading them is no less active and can bring significant profits. The only noticeable difference is usually the higher spread (the difference between the buy and sell price) compared to the major pairs.

To effectively analyze and trade cross-currency rates, traders must also take into account the fundamental factors that affect both currency units that make up them. These include economic data, static indicators, important political events, speeches by central bank governors, and technical analysis. Speculators and investors often use currency pair crosses to diversify their portfolio and avoid risks.

Why do traders need cross-currency exchange rates?

Any currency pairs on Forex are used for one purpose – to profit from speculation. Simply put, a trader wants to buy cheaper and sell more expensive, making a profit due to the difference in price. But, in addition, cross-courses provide market participants with additional opportunities to diversify their investments.: they can diversify their portfolio by investing in different currencies, thereby reducing the impact of the US dollar on it. In this way, you can also protect your investments from economic risks associated with specific events or factors affecting a particular country or region.

Another advantage of using cross-currency exchange rates is the expansion of investment opportunities. When markets are waiting for the formation of a new trend with major pairs, you can include crosses in trading, focusing on technical or fundamental analysis.

How cross-courses are formed

On Forex, you can buy one currency for another in a variety of ways. Do not forget that this is an interbank market that does not have a single platform. Therefore, it is logical that transactions can be very diverse. However, it is quite obvious that there are much more positions opened with the US dollar than with other foreign currencies. Therefore, in order to correctly generate cross-pair quotes, the calculation does not go directly, but through transactions with USD.

Let's take an example of how the quote of the GBP/CHF pair is obtained: when a market participant requests its purchase, in fact, he buys a dollar for a franc at the USD/CHF exchange rate, after which he uses the dollars earned to buy pounds at the current GBP/USD price. For us, everything happens automatically, but the calculation involves two conversions at once.

The location of currencies in the cross rate is also not chosen by chance, they depend on the main pairs involved in the formation. So, if one of the currencies with the dollar is in the direct quote, and the other in the reverse, then the first in the cross pair will be the currency with the direct quote. For example, EUR / CHF or GBP / JPY. If both currencies are in the same position, then their mutual location is determined as it has developed historically. For example, EUR / GBP.

How to calculate cross currency rates

When calculating the cross of currency pairs, remember that for this currency exchange process, a third currency unit is used – the US dollar. It is important to consider whether direct or reverse quotes are used.

Recall that a Direct Quoteis the cost of one unit of foreign currency, expressed in USD. For example, if the EUR / USD exchange rate is 1.20, it means that 1 euro is worth 1.20 US dollars.An Indirect Quoteis the value of one US dollar in a foreign currency. For example, if the USD / JPY exchange rate is 110, it means that 1 USD is worth 110 Japanese yen.

As a result, cross-currency rates are calculated using the following two formulas:

1. For two direct quotes, for example, in the EUR / GBP pair

Cross rate = Direct quote of the first currency. Direct quote of the second currency

EUR/GBP = EUR/USD ÷ GBP/USD

2. For pairs with forward and reverse quotes, for example, EUR / JPY

Cross rate = Direct quote of the first currency * Reverse quote of the second currency

EUR/JPY = EUR/USD * USD/JPY

For traders who see the flow of quotes in the terminal, these calculations are invisible, as they are made automatically. But it is good to understand the principles of forming cross-currency rates.

Key factors influencing cross-courses

In order for cross-currency trading to be effective, a trader must take into account in his analysis the ratio of the economic state of the two countries whose banknotes are included in the pair. To do this, it is important to pay attention to the following fundamental indicators:

  1. Macroeconomic statistics, such as GDP, inflation, unemployment, trade balance, and so on. The more stable the value of indicators, the greater the interest of investors in this country, and the exchange rate of its currency tends to rise.
  2. Monetary policy and speeches of Central Bank governors. Decisions on interest rates, forecasts of officials regarding monetary policy – all this is reflected in the local currency quotes immediately. In the analysis, you need to look at which country's situation is more favorable.
  3. The political and geopolitical position of states in the world is very noticeable on the quotes of pairs with the local currency. Elections, conflicts, sanctions, and wars affect investors ' interest in a country's assets, including its currency.
  4. The state of the trade balance between states is also important. If one country has a long-term trade deficit, this can put pressure on its currency, especially in cross-rates with the money of the creditor country.
  5. Developments in global markets, such as changes in the prices of oil, precious metals and other commodities, can also affect cross-rates, especially for export-oriented countries.

Advantages of cross-rate trading

Cross-rate trading has its own advantages and risks, which should be considered when deciding whether to include them in an investment portfolio.

The advantages include:

  1. The ability to diversify investments that reduce the risk of complete loss of the deposit.
  2. High volatility in comparison with the main pairs, which creates the potential for more earnings with a properly constructed analysis.
  3. Reducing pressure from changes in the US dollar exchange rate on investment performance.
  4. The ability to use cross-rates to win back strong, but local news that does not have a noticeable impact on the main currency pairs.
  5. A large number of different variants of cross-pairs, among which you can find interesting signals at the moments of flatness in the majors.

The following risks should be taken into account:

  1. Relatively large spreads. If they tend to zero in the main pairs, then they can reach up to a dozen points, especially at the time of important news releases. Despite this, today the FxPro broker offers its clients some of the most comfortable conditions for trading these assets.
  2. Relatively low liquidity, which in certain cases can create slippage and requotes when exiting trades. This is especially noticeable at night or on weekends. Then cross-pairs can behave very unpredictably.
  3. Increased risk of rapid losses due to high pair volatility.
  4. Information for cross-rate analysis may be less accessible than for the main pairs, which may make it difficult to make fundamentally sound decisions.
  5. Cross-rates may be exposed to specific risks related to the economy and politics of the countries whose currencies make up the pair. For example, political instability or economic crises in one of the countries of the pair can significantly affect its exchange rate.

When trading cross-rates, it is important to conduct a thorough analysis of the situation and have a risk management strategy. It is also recommended to start trading with small positions and increase them as you gain experience.

Conclusion

Cross-rates in the Forex market play a significant role, allowing you to significantly expand your trading opportunities and diversify your portfolio. However, it is important to remember that trading them involves risks associated with low liquidity, high volatility and spread expansion.

Therefore, successful cross-rate trading requires detailed analysis, a good understanding of the market, and a risk management strategy. As a result, the decision to include these assets in the portfolio largely depends on the trader's goals, tactics and acceptable level of risk.

Learn more about the nuances of trading in the foreign exchange market in the training section on the FxPro broker's website.

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