Cross-Currency Transactions: Definition & How They Work

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. dollarsUnited States Dollar (USD)The United States Dollar refers to the national currency of the U.S and is represented by the ISO code USD and is often abbreviated as US$. 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 swapsCross Currency SwapCross currency swap refers to an agreement between two parties to trade currencies. Over the duration of the swap, the interest payments are exchanged periodically, 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 arbitrageTriangular Arbitrage OpportunityA triangular arbitrage opportunity is a trading strategy that exploits the arbitrage opportunities that exist among three currencies in a foreign currency exchange. The arbitrage is executed through the consecutive exchange of one currency to another when there are discrepancies in the quoted prices, 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.

Additional Resources

CFI is the official provider of the global Capital Markets & Securities Analyst (CMSA)®Program Page - CMSAEnroll in CFI's CMSA® program and become a certified Capital Markets &Securities Analyst. Advance your career with our certification programs and courses. certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional CFI resources below will be useful:

• Cross Currency SettlementCross Currency Settlementa cross currency pair refers to a currency pair that does not use the U.S. dollar for both the transaction currency and the settlement currency.
• FX Rates – CurrenciesFX Rates - CurrenciesThe Table below has FX Rates for major Currencies, as compared to the USD. The USD is the most widely traded currency in the world, and is involved in over 81% of all forex trading. The USD is popularly referred to as the Greenback, due to its bill colour.
• Hedging ArrangementHedging ArrangementHedging arrangement refers to an investment whose aim is to reduce the level of future risks in the event of an adverse price movement of an asset. Hedging provides a sort of insurance cover to protect against losses from an investment.
• Spot Exchange RateSpot Exchange RateThe spot exchange rate is the current amount one currency will trade for another currency at a specific point in time.