Cross Rate Essay ⋆ Business Essay Examples ⋆ EssayEmpire

A cross rate reflects the exchange rate between a foreign currency and another foreign currency. It shows the relationship between two foreign currencies with neither currency being the domestic currency. If the exchange rate between U.S. currency and country X’s currency is known, and the exchange rate between U.S. currency and currency of county Y is also known, it is possible to determine the implied exchange rate between the currencies of countries X and Y. The implied exchange rate is what is referred to as a cross rate.

Foreign exchange rates can be quoted in two ways: direct quote and indirect quote. A direct quote is stated in the form of domestic currency per foreign currency. An indirect quote is expressed as the number of foreign currency units needed to acquire one unit of domestic currency. A direct quote is also referred to as a normal quote, while an indirect quote is called a reciprocal quote. An example of a direct quote between the U.S. dollar (USD) and the British pound (GBP) is USD/GBP = 1.90. This means that $1.90 of U.S. currency is needed to purchase a unit (₤1) of British currency. The direct quote can be converted into an indirect quote of the form, GBP/USD = 0.53. Again, this means that ₤0.53 British currency is needed to purchase a unit ($1.00) of U.S. currency.

The cross rate is usually calculated from two other foreign exchange rates. Let the exchange rate between U.S. dollar (USD) and South African rand (ZAR) be stated as USD/ZAR = 7.5. Again, let the exchange rate between U.S. dollar (USD) and Mexican peso (MXP) be stated as USD/MXP = 10.5. From these two quotes, it is easy to determine the implied cross rate between ZAR and MXP. The cross rate is MXP/ZAR = 0.71 (calculated as 7.5/10.5).

In order to understand the rationale for its use, it is important to examine the concept of vehicle currencies. Vehicle currencies are currencies that are actively traded in the foreign exchange market. Examples of vehicle currencies are U.S. dollar (USD), euro (EUR), Japanese yen (JPY), and the British pound (GBP). International transactions are conducted in a few vehicle currencies. The logic for using a few currencies for international transactions is to promote efficiency. If the number of currencies used in international transactions is denoted as N, then there are N(N-1)/2 possible exchange rates. The larger the value of N, the larger is the number of exchange rates to be determined. Therefore, it makes sense to use a few currencies for international transactions and then infer the cross rates from existing relationships among trading currencies of the world. The Wall Street Journal publishes a table of cross rates daily.

The foreign exchange market is an integrated market that is made up of a network of large commercial banks in the major financial centers of the world. The existence of modern communication technology means that information is quickly transmitted in the market. Thus, all the markets are linked together. This is the reason why quoted exchange rates are consistent. For example, the USD/GBP rate quoted in New York is not significantly different from the USD/GBP rate quoted by a London bank.

Bibliography:

Ball and W. McCulloch, International Business (Irwin McGraw-Hill, 1999);
Bekaert and R. J. Hodrick, International Financial Management (Pearson Prentice-Hall, 2009);
Livingston, Money and Capital Markets (Kolb, 1993);
Melvin, International Money & Finance (Pearson Addison-Wesley, 2004);
J. O’Brien, International Financial Economics (Oxford, 2005).

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