Introduction
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What is the cross currency basis?
The cross-currency basis is a term used to describe the difference between the interest rate earned on a specific currency in the cash market and the cost of borrowing that same currency in the forward market. It essentially indicates the balance between the demand and supply for a particular currency in the foreign exchange market.
Let's break it down:
Cash market: This is where currencies are exchanged for immediate delivery. The interest rate earned on a currency in the cash market is reflected in the interest rate offered for depositing that currency.
Forward market: This is where contracts are made to buy or sell currencies at a predetermined exchange rate on a future date. The cost of borrowing a currency in the forward market is reflected in the forward premium or discount.
Understanding the Cross-Currency Basis: Positive basis: This occurs when the forward premium is higher than the cash interest rate. It suggests that there is a greater demand for the currency in the forward market compared to the cash market. This could be due to factors such as:
Anticipated appreciation of the currency in the future.
Investors looking to protect themselves against potential depreciation of their holdings in another currency.
Negative basis: This occurs when the forward discount is higher than the cash interest rate. It suggests that there is a greater supply of the currency in the forward market compared to the cash market. This
could be due to factors such as: Anticipated depreciation of the currency in the future.
Investors looking to borrow the currency for short-term purposes.
What is an example of a cross-currency swap?
Two companies, Company A in the United States and Company B in Japan, are in need of funding for their operations in each other's countries. Company A requires ¥100 million in Japan, while Company B needs $10 million in the US. To address the issue of expensive borrowing rates, they can engage in a cross-currency swap. In this arrangement, they would exchange principal and interest payments in their respective currencies for a set period, such as one year. This allows both companies to access the funds they need at potentially more favorable rates.
Company A and Company B engage in a cross-currency swap where they exchange fixed interest payments on notional principal amounts of ¥100 million and $10 million respectively. This arrangement allows both companies to borrow cost-effectively and hedge against exchange rate fluctuations, providing a clear benefit for each party involved. Remember, real-world swaps can be more complex, so it's essential to understand all the variables involved.
What is cross rates explain with examples?
Cross rates, also referred to as cross-currency rates, are exchange rates that involve two currencies without the inclusion of the US dollar (USD). These rates provide valuable information on how much of one currency you would need to exchange for another.
Let's break down this concept with some examples:
Why Cross Rates are Important:
Typically, currency quotes are displayed against the USD as the standard benchmark. However, there are instances where businesses and individuals require direct currency exchanges without involving the USD.
In such cases, cross rates become essential as they allow you to determine the exchange value between two specific currencies you are interested in.
Calculating Cross Rates:
Although cross rates may not be directly quoted everywhere, they can be calculated using the available USD-based exchange rates. Here's the formula:
Cross Rate (Currency A / Currency B) = Currency A / USD * USD / Currency B
Example 1: Euros (EUR) to Japanese Yen (JPY)
Let's say you come across the following exchange rates:
EUR/USD: 1.20 (meaning 1 Euro equals 1.20 US Dollars)
USD/JPY: 110 (meaning 1 US Dollar equals 110 Japanese Yen)
To find the EUR/JPY cross rate:
EUR/JPY = 1.20 EUR/USD * 110 USD/JPY = 132
Therefore, based on the given exchange rates, 1 Euro is approximately equivalent to 132 Japanese Yen.
Version 1:
Imagine you come across these rates:
GBP/USD: 1.35 (which means 1 British Pound equals 1.35 US Dollars)
USD/CNY: 6.80 (which means 1 US Dollar equals 6.80 Chinese Yuan)
To determine the GBP/CNY cross rate:
GBP/CNY = 1.35 GBP/USD * 6.80 USD/CNY = 9.18
Therefore, based on these exchange rates, 1 British Pound is approximately equivalent to 9.18 Chinese Yuan.
Significance of Cross Rates:
Cross rates hold great importance for several reasons:
International trade: Businesses rely on cross rates to calculate costs and profits when engaging in cross-border transactions involving different currencies.
Travel: Tourists can utilize cross rates to estimate the value of their home currency in the country they are visiting.
Investing: Investors frequently monitor and analyze cross rates to comprehend potential currency fluctuations and make well-informed investment choices.
By comprehending cross rates, you can navigate the intricacies of foreign exchange transactions and make more informed financial decisions when dealing with currencies other than the US dollar.
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