All You Need to Know About Cross Currency
Diversification in the portfolio of assets is one of the major things that all investors try to do. The main reasons for this are maximizing the return on investment and hedging against the volatility of the market. One of the assets that are a good choice for investment is currency. With cross-currency trading, you can maximize your gains.
But to trade in the currency market in an efficient manner, you need to understand the market fully, and you have to supplement this knowledge with the necessary skills. So, we will discuss everything about cross-currency trading and what are cross currency pairs.
History of Dominance of the Dollar
Let us turn the page back and get to the end of World War 2. Of course, most of the countries had been monetarily and physically drained after the war was over. But, there were a few countries that actually gained from this war and became prosperous.
One of the most powerful economies that emerged in the era post the war was the United States. After the World War came to an end, the world economies started indulging in international trading. This led to the need for a common yardstick currency. All the other currencies would be pegged against this currency to make sure that there is price parity.
So, because the USA dollar was one of the most stable currencies at the time, it was decided that if any currency needed to be converted to another, then it had to be compulsorily converted to the US dollar.
Also Read: USD INR Trading
The Emergence of Cross Currency
With the beginning of globalisation and enhanced trading volumes between the different countries of the world, the demand for different foreign currencies skyrocketed. But, to buy and sell commodities, two transactions were required:
- First, the nation buying the commodity had to convert its own currency to the US dollar.
- Then, these US dollars had to be converted to the currency of the nation selling the commodity.
However, due to the rapid expansion and growth of the forex market, this process was done away with, and cross-currency exchange trading emerged. Now, investors can indulge in cross-currency exchange and investment without having to involve the US dollar.
So, what are cross currency pairs? Cross-currency pairs are those pairs of currencies that do not involve the dollar.
How to Trade in Cross Currency Pairs?
Almost 88% of the forex trading globally still has the involvement of the US dollar; some cross currency pairs have emerged that lend themselves to derivatives as well as direct trades.
But, you need to understand that trading in cross currency pairs depends on the amount of liquidity that is there between these currencies. It also depends on a few other factors, such as their volatility in concern to other main currencies and the interest rate spreads. If the currencies work based on these factors, then they become the chosen way of trading by the investors.
The first currency in the pair is termed the base currency, while the other currency is called the quote. Most of the contracts are often cyclical, and the forex trade might happen on the NSE; the currency for the settlement is INR(Indian Rupees). The daily settlement happens a day after the occurrence of the trade, while the final settlement takes place after T+2 days.
Strategies to Prepare for Cross Currency Trading
You must develop some strategies if you are planning to take part in cross-currency trading. Here is what will help you:
Trading through derivatives, futures and options has been on the rise in the last few years. For trading in derivatives, you can explore various strategies such as hedging, butterflies, straddles, spreads, and strangles. These traders will involve low and high yield pairs of cross currencies, and the investors will try to make gains by shorting the low yield currency.
- Carry trades
One of the commonly used ways of making gains in cross-currency trading is through carry trades. In these trades, the interest rate arbitrage is exploited by borrowing the low yield currency and lending the high yield currency. The profit margin of the trader is the difference in the interest rates of these currencies. The low-yield currency is known as the funding currency, whereas the high-yield one is referred to as an asset.
It is very important to understand the risks involved in cross-currency trading, and interest is one of the main factors that play a major role in the determination of the risks. Also, while the trading may take place in any cross-currency pairs, the settlement may take place in a totally different currency, and the profits may vary according to this. Moreover, when you start cross-currency trading, choose currencies that act non-volatile against the dollar. This ensures that they are non-volatile with other currencies as well.
Also Read: Risk Management in Forex Trading
Thus, trading between cross-currency pairs can prove to be quite beneficial if done accurately. It allows you to make gains from the difference between the interest rates and also through disparities in the exchange rates of currencies. But, you must understand that this trade involves higher volatility, so you must practice well.
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Frequently Asked Questions
There are some major benefits that you can avail of from cross-currency trading; these include:
- Currencies make for a great investment option if you are looking to diversify your portfolio. Moreover, cross-currency trading can enable you to maximise your gains.
- When you invest in various cross-currency pairs, it acts as a hedge against the high volatility of the rates of the cross-currency pairs and also helps you enhance your gains.
- Cross-currency pairs are great facilitators when it comes to enhancing trade volumes.
Yes, in India, you can take part in cross-currency trading in three pairs of currencies that are GBP/USD, EUR/USD, and USD/JPY.
In the NSE, the cross-currency trading timings are from 9:00 am to 7:30 pm(IST) from Monday to Friday.