What is Cross Rate?
Cross rates, also known as cross currency rates, are exchange rates between two different currencies, where neither currency is the United States Dollar (USD). These rates help determine the value of one currency in terms of another currency directly, without involving the USD as an intermediary.
Understanding Cross Rates
In the foreign exchange (forex) market, most currency exchange rates are quoted against the US Dollar, which serves as the world's primary reserve currency. However, cross rates become essential when traders or investors want to exchange one foreign currency directly for another foreign currency without converting it to USD first.
The calculation of cross rates involves using the exchange rates of the two currencies involved with the USD as an intermediary step. For instance, if a trader wants to know the exchange rate between the Euro (EUR) and the Japanese Yen (JPY), and only the EUR/USD and USD/JPY rates are available, they can calculate the EUR/JPY cross rate by multiplying the EUR/USD rate by the USD/JPY rate.
How to Calculate Cross Rates?
To find the cross rate between two currencies (Currency A and Currency B) when both are quoted against a common third currency (usually USD), use the following formula:
Cross Rate = (Exchange Rate of Currency A / Exchange Rate of Common Currency) * Exchange Rate of Currency B
Let's assume INR (Indian Rupee) as one of the currencies and calculate the cross rate between EUR (Euro) and INR using the USD as the common currency.
Assume the exchange rates are as follows:
EUR/USD = 1.1500 (Euro to US Dollar)
USD/INR = 75.00 (US Dollar to Indian Rupee)
To find the EUR/INR cross rate, we'll use the formula:
EUR/INR = (EUR/USD / USD/INR)
First, let's calculate the value inside the parentheses:
EUR/USD = 1.1500
USD/INR = 75.00
EUR/INR = (1.1500 / 75.00)
EUR/INR ≈ 0.0153333
So, the cross rate between EUR and INR is approximately 0.0153333.
This means that 1 Euro is approximately equal to 0.0153333 Indian Rupees. Keep in mind that exchange rates can fluctuate, so it's always essential to check for the latest rates when making actual currency conversions.
Significance of Cross Rates
Cross rates are essential for:
1. International Transactions: When doing business across different countries, cross rates help with direct currency conversions without involving USD, simplifying transactions.
2. Investments: Cross rates are used by investors to evaluate potential returns and risks when investing in foreign currencies and assets.
3. Currency Risk Management: Businesses use cross rates to manage currency risk, especially when dealing with various currencies in their operations.
4. Arbitrage Opportunities: Traders can take advantage of price discrepancies in cross rates to make risk-free profits.
Cross rates are crucial in the forex market, enabling direct currency conversions between different foreign currencies. They simplify international transactions, aid investors in decision-making, and provide opportunities for traders to profit from currency price differences.