Currency Secrets

Synthetic positions allow forex traders to take advantage of currency pairs when the direct currency cross is NOT offered.

As an example, if you were trading on Oanda you’d notice that the NZD/JPY pair isn’t offered.

Why worry about the NZD/JPY? I hear you ask.

Oh, nothing much, just that Oanda pays long NZD positions 7% per year, and charges 0.32% on short JPY positions – and according to my calculations that’s a nice difference: just buy NZD and short JPY, only problem is NZD/JPY isn’t offered in Oanda.

So what do we do?

Here’s how…

(All interest rate charges and payments are taken from Oanda’s Interest Rate section)

Let’s first of all look a more popular carry trade example: GBP/JPY to illustrate what I’m talking about by the huge difference in interest rates between the NZD & JPY and taking advantage of this.

The GBPJPY cross is quite a popular currency as Oanda pays LONG GBP positions 4.35% per annum, and charges 0.32% per annum on Yen positions. If we were to go long the GBPJPY (which in effect is buying/investing Pounds and selling/borrowing Yen) then we’d receive interest on a daily basis, as the interest received is greater than the interest paid. To illustrate this through an example…

If the GBP/JPY’s asking price was 215.08, and we went long 100,000 Pounds, we have now gone short 21,508,000 Yen (100,000 x 215.08). If we held these positions for a year and the interest rates of these countries were to stay the same we’d receive and be charged the following…

100,000 x 4.35% = GBP 4,350
-21,508,000 x 0.32% = (YEN 68,825.60)

If we convert the YEN back to GBP by assuming that the currency hadn’t moved in a year we’d be paying…

(68,825.60) / 215.08 = (GBP 320)

Our net interest received would then be… 4,350 – 320 = GBP 4,030

If we convert this to the currency of our account, being USD, (and we assume the GBP/USD is at 1.8000 in a year’s time) we would receive US$7,254.

Still with me?

It’s quite a simple process calculating interest rates, but as it is with riding a bicycle it takes going over a few times.

So now that we know how to do this on a direct cross, what happens when we want to do some carry trading on a synthetic pair such as the NZD/JPY?

Well, just as with our GBP/JPY example the net result needs to be: LONG the NZD, and SHORT the JPY. So whatever steps we take we need this as the end result.

One way of achieving this is by going LONG the NZD/USD (we’ll use the asking price of 0.6175), and then LONG the USD/JPY (we’ll use the asking price 115.88).

Here’s the math (and as we want to compare the difference to the GBP/JPY cross we will keep the quantity of YEN the same, being 21,508,000… and with that we’ll start with the USD/JPY trade)…

If we are going to SELL 21,508,000 YEN at 115.88 this means we are in effect going LONG US$185,606 (21,508,000 / 115.88).

As we only want to be LONG NZD we need to neutralise the LONG USD position by offsetting it against a SHORT USD of equal size, therefore we will…

SELL US$185,606 on the NZD/USD pair, which means that we will be LONG NZ$300,576 (185,606 / 0.6175).

So here’s how the sums look…

-21,508,000 YEN
+185,606 USD
-185,606 USD
+300,576 NZD

Which in effect means that we are short 21,508,000 YEN and LONG 300,576 NZD (the USD’s cancel each other out) – we have achieved our intended result!

But what would be the NET carry result in a year’s time (assuming interest rates stay the same)?

-21,508,000 x 0.32% = (YEN 68,825.60)
+185,606 x 4.825% = USD 8,955.50
-185,606 x 5.375% = (USD 9,976.30)
+300,576 x 7.0% = NZD 21,040.30

We would now need to convert the USD and JPY amounts to NZD (we’ll again assume the currency prices haven’t moved for a year!)…

(YEN 68,825.60) => -68,825.60 / (115.88 x 0.6175) = (NZD 961.80)
USD 8,955.50 => 8,955 / 0.6175 = NZD 14,502.00
(USD 9,976) => -9,976 / 0.6175 = (NZD 16,155.50)

Which would now leave us with a net result of…

(NZD 961.80)
NZD 14,502
(NZD 16,155.50)
NZD 21,040.30
NZD 18,425.00

Or, converting that back to our USD balance… 18,425 x 0.6175 = USD 11,377.45 (nearly a 60% increase above our direct currency cross of the GBP/JPY!).

Okay, so what are the disadvantages of synthetic positions?

Probably the most prominent is the fact that you don’t have a direct chart to look at and see where support, resistance, or whatever indicators you enjoy plotting are. If you have a charting package and forex data you could probably work around this restriction by creating code and plotting such a chart – as I’ve done here for NZDJPY in WLD code.

Or, if you don’t have WLD, you could use a free charting service such as Trading Charts and simply enter the synthetic currency into the box underneath the table – i.e. NZDJPY. You can then play with the resulting bar chart according to Trading Charts’ selections.

By looking at a chart you are able to gauge how much you’ll need in reserve to hold the positions for margin requirements.

So, hopefully with this short article on synthetic positions it has helped widen your scope on what is tradable in the forex market, and opened up new opportunities for you. With interest rates on the rise in certain countries carry trading like this should further your interest over the coming months and years – I especially like it because you don’t need to do too much!

Tags: Forex Trading

This entry was posted on Thursday, July 27th, 2006 at 9:41 pm and is filed under Forex Trading. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.