Forex trading involves the exchange of currencies between different countries. Often, traders buy and sell currencies that are not directly related to their own currency. In such cases, they need to calculate cross rates to determine the exchange rate between two currencies that are not directly traded. In this article, we will explain how to calculate cross rates in forex.
What is a cross rate?
A cross rate is the exchange rate between two currencies that are not directly traded in the forex market. For instance, if a trader wants to exchange Australian dollars for Japanese yen, but the market only provides the exchange rate for Australian dollars and US dollars and the exchange rate for Japanese yen and US dollars, the trader can calculate the cross rate to determine the exchange rate between Australian dollars and Japanese yen.
To calculate the cross rate, traders use the exchange rates of two other currency pairs which share a common currency. This common currency is used as a bridge between the two currencies that are not directly traded.
For instance, let us consider the following currency pairs:
AUD/USD = 0.75
USD/JPY = 110.50
To determine the cross rate between AUD and JPY, we can use the USD as a bridge currency. The process involved in calculating the cross rate is as follows:
1. Determine the exchange rate of the first currency pair.
In this case, the exchange rate for AUD/USD is 0.75. This means that one Australian dollar is equal to 0.75 US dollars.
2. Determine the exchange rate of the second currency pair.
The exchange rate for USD/JPY is 110.50. This means that one US dollar is equal to 110.50 Japanese yen.
3. Divide the exchange rate of the first currency pair by the exchange rate of the second currency pair.
To calculate the cross rate between AUD and JPY, we need to divide the exchange rate of AUD/USD by the exchange rate of USD/JPY. This can be expressed as follows:
AUD/JPY = AUD/USD ÷ USD/JPY
= 0.75 ÷ 110.50
= 0.0068
This means that one Australian dollar is equal to 0.0068 Japanese yen.
Why calculate cross rates?
Traders may need to calculate cross rates when they want to trade currencies that are not directly related to their own currency. They can use cross rates to determine the exchange rate between two currencies without having to convert their currency into a bridge currency such as the US dollar.
For instance, if a trader wants to buy Japanese yen with Australian dollars, they can use the cross rate to determine how many Japanese yen they will receive for a certain amount of Australian dollars. This can help traders to make informed decisions when trading currencies.
Conclusion
Calculating cross rates in forex involves using the exchange rates of two other currency pairs to determine the exchange rate between two currencies that are not directly traded. Traders use cross rates to determine the exchange rate between two currencies without having to convert their currency into a bridge currency. By understanding how to calculate cross rates, traders can make informed decisions when trading currencies.
