Important aspects of cross currency pairs in india.
Currency and Commodities
23 February 2021 6:13:PM
What is a cross-currency pair? To understand the cross-currency pair, we must first understand the currency pair in detail. All currency trading is done in pairs; you must buy one currency and sell another currency in the currency market. Nearly all cross currencies are priced out to the fourth decimal point which is termed as pips that are percentage in point is the smallest increment of trade. One pip typically equals 1/100 of 1%, in the above example EUR/USD= 1.2175 the last two decimal are pips.
Why there was a need for cross currency pairs? During the Bretton Woods system, US Dollar was considered the strongest currency as it was backed by Gold. Hence, all the currencies were pegged or quoted against the Dollar. So if someone wanted to change currencies, he would have to first convert the currency he holds into USD and convert USD into the desired currency. For example, If someone wanted to exchange Indian rupees into Japanese Yen, then the holder of INR had to first convert INR into USD, and then convert USD into JPY.
With the invention of Cross currency. An individual can direct convert his holding currency into the currency he desires, without going through the whole process of converting it into USD. The cross-currency pairs traded in India are GBPUSD, EURUSD, and USDJPY and other than this GBP/JPY, EUR/JPY, EUR/CHF, and EUR/GBP are other cross currency traded worldwide.
Why is the US dollar dominating? US Dollar is still the dominant currency in the world reason being all the major agricultural products and commodities like oil and metals are quoted in USD. So for the ease of transaction countries need to maintain the US dollar reserve with them in order to buy and sell commodities.
There is an index that measures the performance of the US dollar again the world's major currency which is known as the dollar index (DYX). The major weight is given to Euro, Great Britain pound, Japanese yen, and Canadian dollar respectively.
How to create synthetic currency pair using cross-currency?
Suppose you want to buy EUR/GBP and as we know it is not traded in India, so you need to buy EUR/USD and sell GBP/USD
In similar ways you and create more synthetic pairs such as GBP/JPY and EUR/JPY. But the important thing to note here is that you need to have a common currency between the two pair in your case it was USD which got cancel and the remainder was the currency pair which we wanted to buy (EUR/GBP)