In the foreign exchange market, synthetic currency pairs or synthetic cross currency pairs are artificial currency pairs that are generally not available in the market but one needs to trade between the pairs. A highly traded currency, usually the United States dollar, which trades with the target currency, is taken as the intermediate currency and the offsetting position is taken on the target currency. The use of synthetic cross currency pairs has become less common with the widespread availability of the most common currency pairs in the market.
Video Synthetic currency pair
Ikhtisar
There are many official currencies around the world but not all currencies are actively traded in the forex market. Country-backed currencies or economically and politically stable unions like USD and EUR are actively traded. Also, the more liquid the currency, the more demand for that currency. For example, the United States dollar is the most actively traded currency in the world because of the size and economic strength of the United States and USD acceptance worldwide.
The eight most-traded currencies (in no particular order) are: US dollar (USD), Canadian dollar (CAD), euro (EUR), British pound (GBP), Swiss franc (CHF), New Zealand dollar (NZD), dollar Australia (AUD) and Japanese yen (JPY).
Currencies are traded in pairs. The 8 currencies mentioned above can produce 28 different currency pairs that can be traded. However, not everything is quoted by the forex market maker. Depending on the liquidity of the currency, there are 18 currency pairs quoted by the forex market maker. The couple are:
As soon as the trade should take place for non-trading currency pairs (not quoted) or for couples who do not have sufficient liquidity, alternative routes are taken to make currency pairs. The created pair is known as a synthetic pair. A synthetic currency pair is created by trading two separate currency pairs in such a way as to effectively trade a third currency pair. Typically, USD is taken as an intermediary currency to create the desired cross synthetic currency pair.
For example, AUD/CAD pair can be traded by creating synthetic currency pair from two separate currency. In this scenario, USD can be taken as an intermediary currency. To trade the AUD/CAD pair, the trader will simultaneously buy AUD/USD (buy the AUD and sell the USD pair and buy the USD/CAD pair (buy USD and CAD sales).
Maps Synthetic currency pair
Benefits
- A pair of synthetic currencies allow you to reduce the cost of trading spread.
- Crossing creates more opportunities for traders by giving them more currency to trade.
- Typically, trends and ranges are cleaner across currencies than on major currency pairs.
- Crossing trade allows you to take advantage of interest rate differentials.
Overhead
Trading a synthetic pair requires opening two separate positions. This increases trading costs and exposure to the account. Differences in interest rates between the three countries involved may also negatively impact trade profitability if done overnight.
Synthetic couples are generally used by financial institutions that want to have a big position, but there is not enough liquidity in the market to do it. This is generally not a practical solution in the retail forex market.
One of the problems with creating synthetic currency pairs is that they bind double the amount of margin as would be required if the right pair is offered through the broker. This also means that traders should pay for spreads on both pairs to use in creating synthetic pairs. But this may not be very relevant because if the couple were offered directly through the broker interface, it will most likely have the same deployment cost.
See also
- The foreign exchange market
- World currencies
- International finance
References
Source of the article : Wikipedia
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