What Is a Cross Rate: An Overview?
A cross rate is a foreign currency exchange transaction between two currencies that are both valued against a third currency. In the foreign currency exchange markets, the U.S. dollar is the currency that is usually used to establish the values of the pair being exchanged.
As the base currency, the U.S. dollar always has a value of one.
When a cross-currency pair is traded, two transactions are actually involved. The trader first trades one currency for its equivalent in U.S. dollars. The U.S. dollars are then exchanged for another currency.
- A cross rate by definition may be any exchange of any two currencies that are not the official currency of the country in which the quote is published.
- In practice, any currency exchange in which neither of the currencies is the U.S. dollar is considered a cross rate.
- One of the most common cross currency pairs is the euro and the Japanese yen.
Understanding the Cross Rate
In the transaction described above, the U.S. dollar is used to establish the value of each of the two currencies being traded.
For example, if you were calculating the cross rate of the British pound versus the euro, you would first determine that the British pound, as of Dec. 18, 2020, was valued at 0.74 to one U.S. dollar, while the euro was valued at 0.82 to one U.S. dollar.
The Major Currency Pair
Foreign exchange (forex) traders use the term cross rate to refer to price quotes between any pair of currency in which neither is the U.S. dollar.
Most transactions on the forex are in major currency pairs. That is, one of the currencies being swapped is the U.S. dollar. For example, if you see on a financial news site that USD/CAD is quoted at 1.28, it means that one U.S. dollar is currently equal to 1.28 Canadian dollars.
A cross rate also refers to a currency pair or transaction that does not involve the currency of the party initiating the transaction.
An exchange rate between the euro and the Japanese yen is considered to be a commonly quoted cross rate because it does not include the U.S. dollar. In the pure sense of the definition, however, it is considered a cross rate if it is referenced by a speaker or writer who is not in Japan or one of the countries that use the euro as its official currency. While the pure definition of a cross rate requires that it be referenced in a place where neither currency is used, the term is primarily used to reference a trade or quote that does not include the U.S. dollar.
Examples of Major Cross Rates
Any two currencies can be quoted against each other, but the most actively traded cross currency pairs are the euro versus the British pound, or EUR/GBP, and the euro versus the Japanese yen, or EUR/JPY.
In fact, these two pairs are the only cross-rate currency pairs that appear in the top 10 most traded currency pairs.
The euro is the base currency for the quote if it is included in the pair. If the British pound is included but the euro is not, the pound is the base.
These currencies are actively traded in the interbank spot foreign exchange market, and to some extent in the forward and options markets.
Examples of Minor Cross Rates
Cross rates that are traded in the interbank market but are far less active include the Swiss franc versus the Japanese yen, or CHF/JPY, and the British pound versus the Swiss franc, or GBP/CHF.
Cross rates involving the Japanese yen are usually quoted as the number of yen versus the other currency, regardless of the other currency.
Cross quotes in currencies that are similar in value and quoting convention must be posted carefully in order to prevent mistakes in trading. For example, the New Zealand dollar (NZD) was quoted at 1.07 per Australian dollar (AUD) in late December 2020.
Both of these currencies are quoted against the U.S. dollar. That is, the value reflects the number of U.S. dollars it would take to buy the foreign currency. However, the quote provides no guidance as to which is the base currency. The market convention is to use the stronger AUD, which is also the larger economy, as the base. However, the two currencies trade near parity to each other, creating the potential for a misquote.
Bid-Offer Spread and Cross Rates
Spreads in the minor crosses are generally much wider. Some are not quoted directly at all, so a quote must be constructed from the bids and offers in the component currencies versus the U.S. dollar.