Rise in the Exchange Rate, Synthetic Cross, and Carry. A Legal–Financial Perspective

For several weeks now, operators, managers, and newspapers in Chile have been noting that the exchange rate is unusually high, given that with copper at current prices, the Chilean peso should be trending upward. And indeed, with a simple technical analysis, this is not happening.

There are several factors at play, as in law and finance, but one argument seems undeniable: the Chilean peso has been used as financing for carry trade operations. Benchmark interest rates in Chile are particularly low, since the Central Bank has so far managed to control inflation expectations. If we compare its rate with other jurisdictions, such as Brazil, it is clear that it is financially convenient and legally possible to use Chile as a base for such operations.

Carry trade operations are relatively simple compared to other financial strategies, but the details required for their configuration remain surprising. This brings us to the so‑called synthetic cross.

Financial Operation

In financial terms, when we speak of a synthetic cross, we refer to an operation—generally involving currencies—that allows gains to be obtained from relative value.

When we trade currency pairs (e.g., AUD/USD), if we look closely, we are investing directionally in two assets at the same time. By doing so, we are betting that the AUD will strengthen and the USD will weaken. Clearly, if we buy AUD as the base currency, the operation assumes it will appreciate, while selling the quoted currency (USD) reflects a negative outlook on it.

The problem, however, is the so‑called “noise” of the quoted currency (USD). Even if our operation succeeds, it cannot escape volatility and systemic risk. A good example would be that, while the position is open, the Federal Reserve raises interest rates, causing losses due to the global strength of the dollar.

The point is that the operator seeks to isolate that noise, eliminating everything unrelated to the performance of the target currency. Thus, to isolate the noise, a financing currency is used. If we expect the AUD to strengthen, we want to go long, but without being exposed to the USD. For this, we look for a financing currency—that is, a currency from a country with low interest rates or signs of weakness, such as JPY or CLP.

Therefore, in our example, we will use CLP to buy AUD. Financially, we are short CLP and long AUD.

Specifically, the operation will be carried out in several steps:

(i) Going long in the target currency, buying AUD and selling USD in the same transaction (profit if AUD rises, but loss if USD strengthens). 

(ii) Building the hedge to exclude the noise, going short in the financing currency, seeking to neutralize the short USD position created in the previous step. This is done by buying dollars (USD) using another currency—in our example, CLP. Here we are short CLP and long USD. 

(iii) Net effect: the synthetic cross is the final financial step. By holding both positions simultaneously with the same notional value, the exposure to the dollar is canceled.

Canceling exposure to a currency is precisely what we sought. Thus, in the target operation we are long AUD (+) and short USD (–); in the financing operation we are short CLP (–) and long USD (+); therefore, the net USD exposure is zero (0), fully neutralized.

It is called synthetic because we synthetically create an AUD/CLP position, without being affected by the global movement of the USD, since whatever we gain or lose in one USD leg, we lose or gain in the other.

Financially, there are two critical variables that determine whether the operation is profitable. On the one hand, the interest rate differential (carry): by going long one currency and short another, we are not only seeking capital appreciation, but also benefiting from the rate differential between the yield of the target currency and the borrowing cost of the financing currency (CLP—unless the Chilean Congress were to prohibit compound interest, as a basic principle in mathematics). On the other hand, we must analyze the volatility adjustment (beta neutral): to neutralize a currency in the synthetic cross, it is not enough for both operations to be aligned in price and volume; the pair must be adjusted to historical volatility. Otherwise, if the speed of appreciation or depreciation differs between currencies (generally influenced by liquidity), profitability may be reduced.

Legal Operation

In principle, the operator’s team must choose between an OTC market (spot or forward) or an exchange‑traded market (futures). In both cases, it is necessary to agree upon a master agreement, which as its main feature grants access to the market, and a transactional agreement, which perfects the specific operation.

In the case of OTC transactions, the master agreement generally corresponds to the standard ISDA (International Swaps and Derivatives Association) contract or the so‑called FX account opening agreement (with CFDs). The transactional contract will correspond to an FX spot or forward contract (if it is term‑based). If it is spot, it must be noted that settlement and clearing will still require a period (T+2). These transactional contracts are usually traded in interbank currency markets, through the respective intermediary, as a decentralized market (commercial banks, investment banks, central banks, etc.). In this market, party autonomy is highly relevant, since the details of conditions and terms can be negotiated (they are not standardized). And if we choose spot, it is not a derivative, since only the forward is strictly considered a derivative. This is relevant, because doctrine has debated whether the entire operation (carry with synthetic cross), even if it does not necessarily involve derivatives, can nonetheless be classified as a derivative.

By contrast, the exchange‑traded alternative requires reviewing the brokerage or intermediation master agreement to determine whether such an operation is permitted. The transactional contract, in turn, takes the form of a currency futures contract (both for the target currency and the financing currency). The venue will be an organized exchange authorized by the relevant authority, being centralized, public, and standardized, which reduces the strength of party autonomy. The important point here is that, in either case, we are always dealing with a derivatives contract, because standardization leads exclusively to futures transactions.

It should be noted that, as in Chile, these operations may be classified as foreign exchange transactions, regulated by an entity such as the Central Bank.

Then, in OTC markets, transactional contracts may include clauses on:

(i) Delivery and payment, where physical delivery (Deliverable) exists, creating an obligation to deliver the notional amount that produces a differential between the currencies, on the agreed date (forward);

(ii) NDF or Non‑Deliverable Forward (netting), generally used in markets with limited depth and frictional banking interconnection, where there is no obligation to deliver a specific amount of the traded currency, and the obligation is extinguished by paying the differential in USD or another instrument denominated in that currency, reduced to the calculation between the agreed exchange rate and the rate at maturity;

(iii) CSA (collateral obligation), generally within the framework of an ISDA‑type contract, where margin guarantees (collateral) are required to cover daily fluctuations in the contract’s value (Mark‑to‑Market). The final obligation is also extinguished through autonomous execution or self‑execution of the collateral (a highly debated issue in law).

In the case of the exchange‑traded alternative (futures), we encounter obligations and rights related to mandatory guarantees (margins), which require the operator to establish a deposit (pledge, loan, or commodatum of fungible goods, depending on doctrinal position) in the traded currency or another, for an initial amount, before opening the position.

With margins, other obligations arise, concerning the duty or right to contribute or demand part of the margin depending on the variation of the open position. This relates to the daily settlement of profits and losses, as a potential daily obligation to perform and deliver at the close of each trading session the asset of the deposit, as indicated by the clearinghouse, according to the formula of debiting the account of the open position (or, as the case may be, the right to demand resources exceeding the required deposit). We add the obligation popularly called the Margin Call, when the balance of the respective account fails to cover the maintenance margin, allowing the enforcement of the acceleration clause or early termination of the term. Finally, in an exchange‑traded context, the operator has the right to close the position early, so that the obligation may be extinguished at any time (debated as to whether it is the same or a different obligation), since the term is stipulated in favor of the debtor, without aiming to protect any interest of the creditor (either because the contract will in any case be executed at the initially stipulated term—by another debtor who buys the future—or because the creditor is indifferent as to who performs), by executing the reverse transaction.

These contracts are bilateral, onerous, commutative or aleatory (depending on the definition adopted of “aleatory”), consensual and atypical (typical for those who see in tax law a regulation of derivatives, e.g., in Chile); they are commercial acts (for some, even absolute mercantile acts); a commercial mandate necessarily intervenes (intermediation and counterparty, executed through a self‑contract on the account and risk of the intermediary); they are financial instruments for risk management in the banking sector, thus becoming relevant in balance sheets, in financial market infrastructure, and in regulatory capital; they are supervised by the relevant authority; and an account‑entry system is used, through the system of novation by central counterparties, especially in futures (there is no relationship between buyer and seller—or at least it is extinguished immediately for those who see novation—since the clearinghouse interposes itself between both, becoming a party to both contracts, as intermediary and dependent party).

In summary, we find master agreements, guarantees, FX spot or forward, futures, and—importantly—every act may be unilaterally executed if something goes wrong by the respective intermediary (broker, bank, or clearinghouse).