A question that comes up sometimes from new forex traders is whether the cross rate currencyÂ pairs such as EUR/JPY and AUD/NZD actually trade or whether they are just calculated figures. Unfortunately, I’ve seen some more experienced traders respond incorrectly (or at least unhelpfully), notÂ clarifying the situation at all. Getting the answer to that question requires answering a very simple secondary one:
Do countries trade directly with each other?
The foreign exchange market is first and foremost a market for the conversion of currencies from one to the other to facilitate international trade and capital movement. If a company in the US is buying something from a company in Japan it will probably have to convert USD into JPY for the transaction (or the Japanese firm will do it on their side when they receive the funds).Â So what happens when a company in Europe wants to buy something from Japan? The firm isn’t going to first convert EUR into USD and then USD into JPY. That would be foolish and add to the expense of the transaction (corporates are subject to bid/ask spreads too). Any corporate Treasurer who did that would find himself unemployed very quickly. They are going to do the direct converions of EUR to JPY.
So basically, the more trade and capital flow there is between two countries the more volume of forex action there is going to be in that currency pair. Obviously, that means some pairs are going to be more active than others.
Now, having said that, cross rates are definitely calculated. But so too are the majors. It’s a simple fact of the market makers’ computers keeping prices in line. Remember your triangluar arbitrage. TheÂ EUR/JPY rate, for example, must equal EUR/USD x USD/JPY (before accounting for spreads). As such, if there’s something which moves one part of the triangle, the other parts must be adjusted to keep the relationships in place.
The bottom line is that crosses do trade, though for the most part the volumes are lower than those of the majors.