Investors try to diversify their portfolios using different asset classes, mainly for two reasons, to hedge against volatility and to optimise the return on investment. Currency makes a good investment choice, and you can increase your profit margin with cross currency trading. But to trade efficiently in the currency market, you have to couple your knowledge with your skills.
A brief lesson in history
Before we begin discussing details of cross currency trading and its ins and outs, let’s take a look at its history.
Cross currency trading started in post WWII world. As the countries got engaged in international trade, there arose a need to have one currency which can be treated as a yardstick. The other currencies can be converted against it to maintain price parity in the international market.
In the aftermath of the Second World War, the U.S. economy emerged as one of the strongest in the world and hence, it was set as the precedent for conversions between other currencies in foreign exchange. As a result, anyone who wanted to exchange a sum of money and convert it to a different currency would often have to convert it to U.S. dollars first, followed by the currency of their choice.
So, literally, it involves two transactions. First converting domestic currency to the dollar and then again, changing it to another.
While direct trades were sometimes possible, they might have had to go through a dollar calculation before being settled. However, in recent years, due to the rapid growth and expansion of the forex market, this system has been abandoned in favour of direct cross currency trading between pairs of currencies.”
Since the gold standard was abandoned, trades between cross currency pairs have become very common as they are far more convenient and cheaper. This is because only one spread is crossed during this process, with non-USD pairs now traded with higher frequency allowing for tighter spreads.
So, does that mean you can now freely trade in any currency pair? The answer is, yes. Most currencies are now listed on the National Stock Exchange. These types of transactions are very common among multinational corporations that hedge their currency exposure. They are also utilised by forex traders who often take up positions in response to ongoing world events.
However, while around 88% of global forex trading still involves the U.S. dollar, there are a number of newer cross currency pairs that lend themselves to both direct trades and derivatives.
But it depends on the degree of liquidity between the currencies along with factors such as interest rate spreads and their volatility concerning other major currencies. Certain currencies are matched based on such parameters and become some of the preferred methods of trading for investors. The first currency in the pairing is the base currency, while the second one is the quote. Contracts are often cyclical, and while trading may occur in foreign currencies on the NSE, settlement always takes place in Indian Rupees. The daily settlement takes place a day after the trade occurs while the final settlement occurs two days after.
To trade in cross currency pairs, you need to develop a strategy that will help you wade through the choppy water. Here is what will help you prepare.
Derivative trades through futures or options are a steadily growing area of forex trading. A wide variety of strategies that can be explored, such as hedging, spreads, straddles, butterflies, and strangles can be explored through options or futures. These will often involve high and low yield cross currency pairs and attempt to profit from by shorting low yield currencies.
Another commonly employed method is carry trades which exploit interest arbitrage by borrowing low yield currencies and lending in high yield ones. The difference in interest rates denotes the profit margin for traders with the low yield currencies referred to as ‘funding’ currencies and the high yield ones referred to as ‘assets’. Currencies from countries with similar exports often make good pairs.
So, what about the risks involved in cross currency trading and how you can hedge against those.
Interest rates play a huge role in determining the risks involved in cross currency trading, particularly in carry trades. Additionally, as settlements may not take place in the same currency as the trades themselves, profits may vary accordingly. When pairing currencies for trades, look for pairs that do not exhibit volatility against the U.S. dollar as they will usually behave in a non-volatile manner towards one another as well.
Cross currency pair trading allows you to diversify your portfolio. It allows traders to profit from both differences in interest rates at different economies as well as from exchange rate disparities. But it takes some practice to trade with confidence since it also involves high volatility.