If you are active on the foreign exchange (forex) market, buying and selling different global currencies, then you may have heard reference to cross rates, or cross-rate trading. This is a slightly complex term in that it has a strict definition but is used slightly differently in practice. Essentially, it refers to price quotes for less widely traded currency pairs, where the exchange rate isn’t commonly quoted and so has to be specially calculated.
Not the home currency
A cross rate is strictly defined as being any exchange of two currencies where neither is the official currency of the country in which the transaction is registered, and which a third currency (typically the home currency) is used to give a rate of exchange and from there a price quote.
In practice, the US dollar is effectively the home currency of the entire forex market, and features in the majority of currency pairs. This means that any currency pair where the US dollar isn’t featured can be described as a cross rate, and the US dollar is usually the third currency used to work out the rate of exchange for the original currency pair.
Establishing a cross rate
A cross rate is achieved using cross-currency triangulation in which a third currency, currency C (the US dollar by default) is used to calculate an exchange rate between currency A and currency B where that exchange rate is not already quoted. Cross-currency triangulation is often used as part of a profitable forex trading strategy.
One of the most common cross-rate transactions would be between the euro and the Japanese yen (note that strictly speaking this would only be a cross rate if it were conducted outside of Japan or the EU). In this case, one would establish the bid/offer valuation for each currency against the US dollar, and then work out their relative value from there.
Base currency
In any price quote for a currency pair, the first currency listed is the base currency and has a fixed value of one. The quote shows how many units of the second currency can be purchased for one unit of the first or base currency. Most forex transactions involve the US dollar, which is usually the base currency. For example, USD/JPY 109.7 means that one dollar is worth 109.7 Japanese yen.
In a cross-rate currency pair, one currency must be the base currency for the purposes of a quote, even if the US dollar is used as a third fixed point to generate that quote. This means that, outside of the major currencies, there can be scope for confusion and even misquotes if there isn’t a commonly understood convention about which currency is acting as the base. Usually, the higher valued currency is the base, but if two currencies are close in value, this may be misunderstood.
Cross-rate spreads tend to be wider than those using major currencies, and the more obscure the currencies involved, the wider the spreads become. Beginners should approach cross-rate transactions with caution but should still go ahead if the price seems right.
