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A cross currency transaction involves the use of more than one currency. For example, you may be involved in a cross currency transaction in order to convert one currency into another currency. Previously, an individual who wanted to exchange one currency into another currency would need to convert their money into U.S. dollars before the transaction could take place.
Due to the rise in demand for foreign currencies and the growth of the foreign exchange market, cross currency transactions can now be made without first converting currencies into U.S. dollars. This has led to the rise of using cross currency pairs in the foreign exchange market. A cross currency pair refers to a pair of currencies that does not involve the U.S. dollar.
When are Cross Currency Transactions Used?
Debt transactions that involve multiple currencies often utilize cross currency swaps, which are contracts used to borrow money at a more favorable rate. A currency swap involves two parties who agree to exchange interest payments and the principal in different currencies.
Cross currency transactions are also utilized with foreign currency deposits, when investors want to hedge against fluctuations in foreign currency.
As a result, investors who are engaged in a transaction that uses more than one currency usually do so if there is an opportunity to hedge against financial risks. Sometimes, investors may also want to utilize cross currency transactions to earn a profit through an arbitrage strategy.
Furthermore, cross currency transactions are used in cross-border payments. Banks that allow such transactions provide more flexibility for customers to receive and provide cross-border payments. It also further increases the demand for global trading and international payments.
How Do Cross Currency Transactions Play a Role in Arbitrage?
Cross currency transactions can be used as part of one’s arbitrage strategy to buy and sell different currencies in order to earn a profit. The strategy is also known as triangular arbitrage, where investors try to take advantage of discrepancies in pricing between various currencies in the foreign exchange market.
Although the strategy enables investors to earn a profit, triangular arbitrage is actually very rare. This is because market imperfections that lead to pricing discrepancies are quickly resolved by the market since prices would constantly fluctuate up and down until there is no longer an arbitrage opportunity.
A triangular arbitrage strategy would involve three different foreign exchange transactions with three different currencies. The first transaction will involve trading an initial currency with a second currency. The second transaction involves trading the second currency with a third currency. The final transaction involves trading the third currency with the first currency.
For example, suppose an investor is interested in purchasing euros with Canadian dollars, and they want to take advantage of the mispricing of the currencies in order to earn a profit from an arbitrage strategy.
Afterward, they sell the euros to purchase U.S. dollars. Using the U.S. dollars, they sell the currency for Canadian dollars. They will earn a profit from the arbitrage strategy if the amount they receive in Canadian dollars is more than what they initially bought.
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