Synthetic Currency Position Strategy is a forex trading approach that involves using a combination of two or more currency pairs to replicate the exposure of a third pair that may be unavailable, illiquid, or less favourable in terms of trading conditions. This strategy is particularly useful for institutional traders, arbitrageurs, and advanced retail traders seeking greater flexibility or cost-efficiency in managing currency exposure.

What is a Synthetic Currency Position?

A synthetic position is created when two currency pairs are combined in such a way that their net exposure mimics another pair. The key lies in how currencies are positioned as base and quote currencies across pairs.

For example, instead of trading GBP/JPY directly, a trader could:

• Go long GBP/USD
• Go long USD/JPY

The net result synthetically replicates a long GBP/JPY position, because the USD cancels out.

This technique relies on the triangular relationship in forex markets, where any three currencies form three pairs that are mathematically interconnected.

How the Strategy Works

1. Identify the Desired Exposure
   Decide the currency pair you wish to replicate synthetically (e.g. GBP/JPY).
2. Break it into Two Legs
   Use two major pairs involving a common intermediary (typically USD). For GBP/JPY:
   • GBP/USD (leg 1)
   • USD/JPY (leg 2)
3. Open the Positions Simultaneously
   Match the size of both trades appropriately to mirror the exposure.
4. Monitor and Manage
   Treat the two positions as one. Monitor P&L and risk as if it were a single synthetic pair.

Example: Synthetic EUR/JPY Position

To synthetically go long EUR/JPY:

• Go long EUR/USD
• Go long USD/JPY

These combine to give long EUR and short JPY, effectively mimicking EUR/JPY.

If EUR/USD = 1.10 and USD/JPY = 145.00, then:

• EUR/JPY = 1.10 × 145.00 = 159.50

This confirms the synthetic exposure aligns with the spot rate.

Applications of Synthetic Currency Position Strategy

1. Trading Inactive or Exotic Pairs
When direct trading is limited or expensive, synthetic positions provide an alternative.

2. Arbitrage Opportunities
If the actual cross rate diverges from the synthetic equivalent, arbitrage traders can exploit price inefficiencies.

3. Cost Reduction
By choosing more liquid pairs with tighter spreads, traders can reduce execution costs.

4. Custom Hedging Solutions
Create tailored hedges for complex exposures not directly available in listed pairs.

Advantages of the Strategy

• Flexibility: Enables access to any cross-currency exposure, even if not directly quoted.
• Efficiency: Can offer better spreads or lower slippage on liquid legs.
• Arbitrage Potential: Reveals mispricing between synthetic and actual rates.
• Strategic Layering: Allows for layered trade setups across multiple instruments.

Limitations and Considerations

• Execution Complexity: Requires simultaneous execution of two positions, increasing operational risk.
• Double Transaction Costs: Two spreads and commissions apply instead of one.
• Margin Requirements: Higher margin is needed for two positions.
• Interest Rate Impacts: Carry costs apply to both legs, potentially altering the net outcome.

Optimising the Strategy

1. Use Correlation Tools
Ensure the synthetic structure mirrors the target exposure accurately through correlation analysis.

2. Automate Execution
Use trading algorithms or multi-leg orders to execute both legs simultaneously and avoid slippage.

3. Monitor Synthetic Rate
Calculate the implied rate of the synthetic pair regularly and compare it with the actual spot market.

4. Watch for Volatility Discrepancies
When volatility spikes in one leg more than the other, synthetic and actual pairs may behave differently.

Implementing Synthetic Rate Calculation in Python

eur_usd = 1.1000
usd_jpy = 145.00

# Synthetic EUR/JPY calculation
eur_jpy = eur_usd * usd_jpy
print(f"Synthetic EUR/JPY Rate: {round(eur_jpy, 4)}")

This confirms the equivalence of a synthetic trade with the actual cross rate.

Use Case: Synthetic Position in Emerging Markets

A trader wants exposure to USD/INR, but liquidity is thin. Instead, they construct a synthetic USD/INR by:

• Going long USD/SGD
• Going long SGD/INR

This offers more favourable execution, especially when both legs are actively traded in local FX hubs.

Conclusion

Synthetic Currency Position Strategy is a highly versatile tool in the trader’s arsenal, enabling tailored exposure, efficient hedging, and arbitrage in situations where direct access is limited or inefficient. By mastering the triangular relationships in currency markets, traders can unlock strategic flexibility and exploit hidden opportunities across global forex pairs.

To learn how to structure, execute, and manage synthetic forex positions with confidence, enrol in our expert-led Trading Courses designed for currency traders seeking an edge in global markets.