What is Cross Currency Trading?
By the time World War II ended, most currencies were pegged to the US dollar, which was further pegged to the gold standard. With the end of the Britton Woods Agreement, the gold standard ended and currencies worldwide subscribed to the floating exchange rate.
This was beneficial for trade, since people who wanted to convert their currencies no longer had to convert them first into US dollars and then into the desired currency. Cross currency transactions were now enabled, which made international transactions easier and cheaper.
With the advent of electronic trading systems, cross currency pair trading flourished.
What are Cross Currency Pairs?
Technically, cross currency pairs are defined as pairs that don’t include the US dollar. Naturally, they exclude the major currency pairs, like EUR/USD and GBP/USD, which are the most traded currencies in the world. Instead, the EUR and Japanese Yen (JPY) are common currencies in these cross pairs.
Further examples of cross currency pairs include GBP/JPY, EUR/GBP and EUR/CHF, all of which are prominent cross pairs. Currency pairs including the euro are often termed as euro crosses. Over the years, cross currency transactions have grown in volume. According to data by the Bank of International Settlements (BIS), an average daily volume of US$82 billion was recorded in April 2016 in cross-currency swaps, which was a significant increase from the US$54 billion figure in 2013.
Calculating Cross Currency Rates
Most trade terminals come with calculated rates of cross-pairs. As the system of converting currencies into US dollars first has been bypassed, only a single transaction is required and only one spread to be considered. With the increase in trade volumes of cross currency pairs, spreads have also become tighter, which means lesser slippage and transaction costs. But, it would be good to understand the mechanism of calculating the cross-rates.
Let us consider two currency pairs that have the USD as the common denominator. Let’s take the GBP/USD and USD/JPY. Together, they make up the popular cross currency pair, GBP/JPY.
Now, suppose the GBP/USD rate is 1.3195 (Bid) / 1.3197 (Ask)
And USD/JPY rate is 110.52 (Bid) / 110.56 (Ask)
To get the bid price of GBP/JPY, we will multiply the bid prices of GBP/USD and USD/JPY, which comes to 145.83.
Similarly, to calculate the ask price of GBP/JPY, we will multiply the ask prices of the major currency pairs, which gives us 145.90.
Hence, the bid/ask rate for GBP/JPY is 145.83/145.90.
Note that this is an approximate value. Market rates can fluctuate across different brokers. Did you know that the GBP/JPY is often referred to as Guppy in market slang, and the EUR/JPY is called Yuppy?
High Correlation between Some Currency Pairs
While the US dollar represents over 90% of daily forex transactions. There are dozens of currency pairs that are affected by each other. Take for instance the euro and the British pound. Till June 23, 2016, when Britain decided to leave the European Union, these two currencies were highly correlated to each other.
Britain and the EU are active trading partners, which results in a high amount of currency exchange on a daily basis. The EUR/GBP is still one of the most liquid cross-currency pairs to trade, with a low average true range (ATR). Another good thing about this pair is that it offers good liquidity in most time zones, including Tokyo, Hong Kong and New York. With the current Brexit negotiations, the pair has shown volatility in recent times.
Since the euro is the domestic currency of the Eurozone, comprising 19 different nations, economic releases have a diluted effect on the currency. Historically, with the exception of the EUR/USD, euro crosses have generally shown lesser volatility in response to US news and economic releases. On the other hand, GBP pairs show a lower tendency for stagnation. They either show an uptrend or downtrend on the charts. UK-related events are also few and easily understandable.
The GBP/CHF pair is another attractive cross-pair. It is much faster than EUR/GBP and has comparatively higher ATR. On the other hand, EUR/CHF has a shorter history of the two currencies, having a significant opposing effect. They were significantly correlated until 2015, when the Swiss Franc was unpegged.
Cross Currency Pairs in Carry Trades
Currency carry trade revolves around uncovered interest arbitrage. Low-yielding currencies are borrowed by investors in exchange for lending in high-yielding currencies. This is usually seen in commodity currency trading, where investors own a high-yielding currency like the Australian dollar (AUD) or the New Zealand dollar (NZD), and sell a low-yielding currency like the Japanese yen. A trader attempts to gain profits from the difference in the currency rates, which can be significant with the leverage included.
Also, the interest rate spreads between these commodity currency pairs, like the AUD/JPY and NZD/JPY, tend to remain high. The currency that has the lower interest rate is the “funding” currency. Traders borrow the funding currency and sell the “asset currency,” with the higher interest rate. These trades are preferred during times of lower market volatility.
Another thing to consider is the monetary policies of the central bank of the funding currency. Economies of countries that have similar exports make up good cross pairs. For example, the AUD/CAD pair relies heavily on commodity exports.
Risks Involved in Cross Currency Trading
Firstly, settlements of cross-pairs are not as simple as major currency pairs. Ample liquidity in these pairs will provide tighter spreads, but on exiting the position, profits will be denominated in a currency different from that of the home currency. Cross currencies could also be expensive to trade. Currency pairs that exhibit volatility against the US dollar will generally show volatility as a cross pair. An example of this is the CAD/JPY or AUD/JPY. In these cases, the bid/ask spread would be higher.
Carry trades have interest rate risks associated with them. The future direction of interest rates is a high risk factor. The 2008 Icelandic financial crisis owes its origins to the significant amount of carry trade activities. Unless a position is hedged properly, small movements in exchange rates can lead to catastrophic losses, particularly when high leverage is involved.