Cross Currency

Have you ever wondered how businesses manage currency risks and conversion costs when dealing with international transactions? These transactions involve exchanging or converting two currencies that aren’t the domestic currency, using currency pairs and derivatives. 

In this article, we will learn the benefits and risks of cross currency transactions and explore how large corporations leverage them to stay ahead in the game.

What is a cross-currency pair? 

Cross currency refers to any currency pair that does not involve the US dollar. It includes major currencies like the Euro, Japanese Yen, British Pound, etc. Cross-currency transactions play an important role in today’s global financial markets. A cross-currency pair consists of two currencies traded in the forex market, excluding the US dollar. For example:

• EUR/JPY – Euro/Japanese Yen
• GBP/AUD – British Pound/Australian Dollar 

A cross-currency pair consists of two currencies: the base currency (first currency) and the quote currency (second currency).

Some commonly traded cross-currency pairs are:

• EUR/JPY
• EUR/GBP
• EUR/CHF
• GBP/JPY
• AUD/CAD

Advantages of trading cross-currency pairs

Here are some major benefits of trading cross-currency pairs:

• Provides more trading opportunities beyond just trading against the US dollar
• Allows taking advantage of the relative strengths and weaknesses between other global economies
• Lower spreads as most cross pairs see lower trading volume
• Potentially lower risk as cross pairs see lower volatility

Using cross-currency in transactions

Cross-currency transactions are deals that involve more than one type of currency. They are a way for individuals or businesses to benefit from differences in interest rates and exchange rates between currencies. This means that people can take advantage of the strengths of different currencies to make the most out of their financial transactions. Some major uses are:

1. Cross currency swaps

A cross-currency swap involves the swapping of principal and interest payments in one currency for paying in another currency. It provides various benefits like:

• Access to lower-cost funding by borrowing in foreign currencies
• Manage exchange rate risk
• Arbitrage interest rate differential between currencies

For example, an Indian company may swap INR loan payments for lower EUR payments.

2. Cross-border transactions

Cross-currency facilitates cross-border business transactions and payments. Parties can pay or receive funds in foreign currencies easily.

For example – An Indian exporter was receiving payment in Japanese Yen.

3. Cross-currency futures 

These futures contracts allow hedging against currency risk. Parties can lock in exchange rates between currencies other than USD.

For example – A British company can hedge GBP/EUR rate risk using futures.

4. Deriving cross-currency exchange rates

Cross-currency exchange rates between two currencies are derived from their exchange rates against a common base currency (usually the USD).

For example:

EUR/USD = 1.05 

USD/JPY = 115

So, Derived rate:

EUR/JPY = 1.05 x 115 = 120

In simple terms:

Base 1 / Quote 2 = (Base 1 / USD) x (USD / Quote 2)

If direct quotes are used, we derive the cross rate as: 

Quote 2 / Base 1 = (Quote 2 / USD) x (USD / Base 1)

The cross rate helps determine the exchange rate between two currencies without the need first to convert them into US dollars.

Things to remember in cross-currency

Here are some key points to remember:

• Know the base currencies and which pairs are quoted directly or indirectly
• Understand the derivation mechanism using USD rates
• Check bid-ask spread, as crosses often have a wider spread
• Manage timing risk arising from deriving cross-rates
• Monitor relevant interest rates and economic factors  

Using cross-currency swaps

Cross currency swaps are popular instruments to manage currency risk. They involve exchanging interest payments and principal in two different currencies between parties. Some key aspects are:

Benefits of cross-currency swaps

• Access lower funding costs – Borrow funds cheaply by swapping to currencies with lower interest rates
• Manage exchange rate risk
• Take advantage of interest rate arbitrage between two currencies
• Diversify funding sources across currencies

Risks Involved 

While cross-currency swaps offer advantages, they also pose certain risks:

• Exchange rate fluctuation risk – adverse currency rate movements can increase costs
• Basis risk between interest rates of two currencies
• Counterparty credit risk  

Hedging cross-currency risks

• Use FX forwards/futures along with cross-currency swaps to lock in exchange rates
• Incorporate termination clauses allowing early exit from unfavourable positions
• Diversify across currency pairs based on correlations
• Dynamically adjust hedge ratios based on evolving currency risk

Cross Currency in International Trade

Exporters and importers extensively use cross-currency transactions to reduce currency risk. Some applications include:

1. Managing receivables and payables

Exporters can choose to invoice in a foreign currency and avoid home currency fluctuation risks. Importers can denominate payables in currencies matching their revenues.

2. Foreign currency loans

Accessing overseas funds in foreign currency helps importers/exporters improve liquidity and hedge currency risk.

3. Diversifying currency exposure

Maintaining foreign earnings in multiple currencies helps manage risk better rather than converting everything to home currency.

4. Payment processing services

Banks provide payment processing, facilitating cross-currency receipts/payments and minimising conversion costs.

Key takeaways on cross-currency

Cross currencies play an integral role in today’s globalised economy and financial system. Let’s summarise the key points:

• It refers to currency pairs excluding the US dollar
• Enables taking positions across other global currencies  
• Used extensively in cross-border transactions, swaps, and hedging activities
• Derived from currency exchange rates against the US dollar  
• Requires understanding of direct/indirect quotes and bid/ask spreads
• Carries risks related to interest rate fluctuations and currency volatility

On the whole, cross-currency pairs and transactions add an extra dimension for participants to manage currency risk better and enable efficient cross-border business. With global trade expanding, we will continue to see increasing cross-currency flows.

Conclusion

Cross-currency management is important in the global economy. It involves using financial contracts to exchange money without the US dollar. This can help companies make more money, but they need to be careful to avoid losing money due to changes in exchange rates. It is important for big companies and investors who do business all over the world.

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