When trading FOREX, investors usually have major currency pairs at their disposal, but if they wish to trade in some of the exotic currency pairs, their options are somewhat limited. The problem that traders face most often is that these exotic currencies are paired up against either the US Dollar or the Euro; therefore, if someone wishes to trade the Mexican Peso against the Japanese Yen, he would be out of luck. Nevertheless, this trade is possible - it just requires a little extra work on the trader's behalf.
In the above example of using the Mexican Peso and the Japanese Yen, a trader could accomplish the desired trade by tying the USD/JPY and the USD/MXN together. The idea in doing this would be to have the zero USD exposure, giving the trader the synthetic MXN/JPY pair. For instance if a trader wanted to go long $5,000 worth of Mexican Pesos against the Japanese Yen, he would need to go short 5,000 units of the USD/MXN (short USD/long MXN), giving them a $5,000 short exposure to US Dollars and a long exposure of $5,000 worth of Mexican Pesos. Then, to create the Japanese Yen aspect of the trade, the trader must then go long $5,000 worth of USD/JPY pair (long USD/short JPY). Combining these two pairs together, the trader has created the MXN/JPY pair, because the USD positions cancel each other out.
The next problem faced when creating synthetic currency pairs is the ability to chart the created pair. Although the amateur investor usually lacks access to affordable software programs that would chart synthetic pairs intraday with technical analysis, Google Finance offers a satisfactory alternative. Their site gives small retail traders the ability to chart any synthetic pair over particular time periods (1 month, 3 month, 6 month, YTD, 1 year, 5 year, and a custom time frame). Although the Google Finance option is extremely limited, it does give traders an idea as to the performance of a particular pair over a period.
While creating synthetic pairs may appear simple, the next problem that a trader will come across is when a trade is in the format of XYZ/USD, where XYZ is a particular currency. In this format, the currency XYZ defines the number of units being purchased. For example, if XYZ is the Euro, then a trader investing $100,000 would be buying approximately 75,188 units of EUR (depending on the exchange rate, I am using the 1.33 and rounding to the nearest whole number). Furthermore, if XYZ is the Australian dollar, then a trader looking to invest $100,000 would be purchasing 119,047 units of AUD currently trading at .87. Currencies commonly formatted like this include the Euro (EUR), the British pound (GBP), the Australian dollar (AUD), and the New Zealand dollar (NZD).
When creating a pair with a currency like those mentioned above, a trader must remember the difference in how he goes about purchasing the units through his broker. For example, a trader may wish to create the EUR/ZAR pair (ZAR is the South African Rand), but the only way to accomplish such a trade through his broker would be to pair EUR/USD and USD/ZAR. At first glance, a trader may think that it is exactly like the above example with the MXN/JPY pair, but since the USD is now purchased in terms of EUR (at today's price of 1.33), it would take $1.33 USD to buy 1 EUR. As discussed, purchasing 75,188 units of EUR/USD would create the $100,000 USD exposure. The number of units depends on the exchange rate of the currency at the time of purchase; to figure out how much of the EUR/USD to buy the trader would take the total USD amount of $100,000 and divide by the current EUR/USD rate of 1.33. This would mean that the trader would have to buy approximately 75,188 units (note: this is not an exact number, it will most likely be a decimal, there might be a small exposure to the USD) of the EUR/USD to get $100,000 in USD exposure. Then the trader would go long 100,000 units of the USD/ZAR pair (similar to that of the above example using USD/JPY), which would effectively cancel out the USD exposure, now giving the trader a synthetic long EUR/ZAR trade.
One of the problems with creating synthetic currency pairs is that they tie up double the amount of margin as would be required if the exact pair was offered through the broker. This also means that the trader must pay the spread on both of the pairs that he will use in creating the synthetic pair. This is not necessarily a problem, because if the pair was offered directly through the broker interface, it would most likely have a similar spread cost. The only disadvantage is the leverage factor, but this is a moot fact, because any intelligent investor would not utilize more than 10 times leverage in trading currencies, even though many of these brokers offer up to 100 times on trades.
Synthetic currency pairs can be difficult to create, but the ability to understand their composition will open many more trading opportunities to traders.