Question about Cross-currency pairs and transaction costs

[juanito27]

Hello, babypips forums!

I was recently referred to this website, in particular to your school (and to forex trading, really). In an online videogame, of all places

Since then, I’ve been attending pre-school as a good boy

After a while, I reached a part in a lesson that confused me (surely this will be the first of many :rolleyes:):

“A cross currency is any pair in which neither currency is the U.S. dollar. (…) Initiating a long (buy) EUR/GBP is equivalent to buying a EUR/USD currency pair and selling GBP/USD. Cross currency pairs frequently carry a higher transaction cost.”

I don’t understand how you can conclude this equivalence.

What my reasoning tells me is that, if my account is in USD, and I want to buy EUR/GBP (Buying EUR by selling GBP, right?), I would need to:

1º - Buy GBP/USD - because I need to sell the USD in my account to get the GBP I need in order to buy EUR/GBP.

2º - Buy EUR/GBP - with the GBP I acquired in step 1º.

I understand that the steps in my reasoning have the same downside of the steps stated in the lesson: they are TWO. Two transactions to do one trade, so you pay transaction costs (spreads) twice.

What I don’t get is how buying EUR/GBP would equal buying EUR/USD and selling GBP/USD.

I’m sure this is a case of me not thinking as a trader yet, but can someone please try to enlighten me?

Thank you very much.

[Master_Tang]

Your misunderstanding here has to do with the way forex works.

You are not buying either currency, you are buying the rights to the difference between the two in U S dollars.

Here’s why they mentioned the two major pairs in a nutshell. If you buy the E/G pair, and either the euro rises in value against the dollar, or the pound drops against the dollar while your trade is open, your trade will be successful. And vice versa for a sell. There is an awful lot more that can happen, but that is the gist of it.

The higher costs mentioned are usually due to the spread being a tad larger, and often the swap rate will be more.

[juanito27]

Your misunderstanding here has to do with the way forex works.

You are not buying either currency, you are buying the rights to the difference between the two in U S dollars.

Guess this is something I’ll have to wrap my head around.

The higher costs mentioned are usually due to the spread being a tad larger, and often the swap rate will be more.

Oh. So you pay more transaction costs only because the liquidity is lower (since the USD is not part of the pair) and thus the spreads will be a bit higher?

If so, I also misunderstood that part of the lesson. Because I thought it meant “if you trade cross-currency pairs, you’ll have to pay more transaction costs, because eventually you’ll want to trade your profits back to USD form, to eventually spend your earnings”.

Thanks for your swift reply, you put me back on the right track

[Master_Tang]

Guess this is something I’ll have to wrap my head around.

Oh. So you pay more transaction costs only because the liquidity is lower (since the USD is not part of the pair) and thus the spreads will be a bit higher?

If so, I also misunderstood that part of the lesson. Because I thought it meant “if you trade cross-currency pairs, you’ll have to pay more transaction costs, because eventually you’ll want to trade your profits back to USD form, to eventually spend your earnings”.

Thanks for your swift reply, you put me back on the right track

if your account is a U S account, you will only ever see your profit/loss in USD form. There are no hidden costs of converting currencies to trade a cross pair.

The initial margin to enter the trade may be higher, because the value of the dollar against the currencies you are trading varies. For instance, right now it would take roughly $13,300 to trade a €10,000 mini lot. Your margin in the US would be 1/50 of that, or $255.00 to open the trade.

I forget the spread rate of the E/G off the top of my head, but it’s somewhere around 5 pips. Then there’s the swap rate that gets a tad more complicated. But you only really need to worry about the swap if you are planning to hold trades longer term.

For swaps, right now about the worst swap rates going are on the Aussie pairs.

So between the extra margin it takes to open a trade, the swap, and the spread, you pay a slight premium to trade crosses.

[juanito27]

Thanks for your last reply.

Some of it I fully understood, like the part about only ever seeing my profit/loss in the form of my “native” currency, that’s good to know.

Some of the other things you said, like that stuff about swaps, I’ll have to research/study further

So, thanks a lot!

[rhodytrader]

“A cross currency is any pair in which neither currency is the U.S. dollar. (…) Initiating a long (buy) EUR/GBP is equivalent to buying a EUR/USD currency pair and selling GBP/USD. Cross currency pairs frequently carry a higher transaction cost.”

This quote needs to be broken down into two parts. The first about going long EUR/GBP being like going long EUR/USD and short GBP/USD is correct. It’s “like” that. That isn’t what actually happens when you do a trade in EUR/GBP, but the effect (excluding transaction costs) is the same.

The second part about higher transaction costs depends on the cross you trade, but that’s true for all pairs, not just crosses. Lower liquidity pairs have higher spreads - be they crosses or non-crosses - which is where the costs come in. The major pairs and crosses are active and have relatively tight spreads. Minor pairs and crosses, and more regional pairs, are less active and have wider spreads.

What my reasoning tells me is that, if my account is in USD, and I want to buy EUR/GBP (Buying EUR by selling GBP, right?), I would need to:

1º - Buy GBP/USD - because I need to sell the USD in my account to get the GBP I need in order to buy EUR/GBP.

2º - Buy EUR/GBP - with the GBP I acquired in step 1º.

This may depend on your broker.

If you’re broker requires to you to post margin in one of the cross currencies, then you would covert the initial margin requirment into that currency and back again at the trade conclusion, adjusted for any gains or losses.

Most brokers, though, have your margin requirement in your account currency, so you don’t need to convert for posting initial margin. In that case, think of it more like when you do a trade in EUR/GBP you are going to end up with a profit/loss in either EUR or GBP (depending on which way you’re trading). That then needs to get converted into USD.

What I don’t get is how buying EUR/GBP would equal buying EUR/USD and selling GBP/USD.

If you go long the equivalent of $10,000 in EUR/USD and short the same equivalent of GBP/USD what you’ve done is sold $10k USD and bought $10k USD. That makes you net flat the USD, but $10k long the EUR and $10k short the GBP. That means long $10k worth of EUR/GBP.