Question Of The Week

• Explanation

A cross exchange rate consists of a pair of currencies, neither of which is the currency of the home country. In this scenario, the currency pair is the euro and the British pound sterling (BPS) and the home currency is the U.S. dollar (USD).

A cross exchange rate is often used by currency traders when currency pairs are inactively traded. The exchange rate can be determined through a currency pair's relationship to a widely traded third currency. Speculators also use cross exchange rates to make interest rate plays and a quick profit in trading back and forth between the three currencies.

To determine the cross rate of euros (€) per BPS (£), first restate each exchange rate as a function of USD (or desired currency), as follows:

• If €1 = $1.48, then $1 = €0.676 (€1 / $1.48)
• If £1 = $2.06, then $1 = £0.485 (£1 = $2.06)

Substitute the restated rate for the euro and the pound, and solve as follows:

$\frac{\text{Euro}}{\text{BPS}*}=\frac{\text{Euro}}{\text{USD}}\times \frac{\text{USD}}{\text{BPS}}=\frac{.676}{1.00}\times \frac{1.00}{.485}=\mathbf{1.39}$

Things to remember:
A cross exchange rate consists of a pair of currencies, neither of which is the currency of the home country. To determine the cross rate, restate each exchange rate as a function of the home currency (eg, if €1 = $1.48, then $1 = €0.676), substitute the restated amount into the cross exchange formula, and solve.

Lecture References :

• BEC 1.06 : Economic Concepts: Financial Risk Management