# How trading in currency pair works, underlying techniques and mechanisms

I am somewhat experienced in Forex trading, but I have a question which has bothered me for quite some time.

If we for instance go back in time four months, to before the beginning of value loss the RUB(RUBLE).

Say that I wanted to make money on the loss of value of the RUB, with my Forex account being based on SEK.

What I am confused about is this, what is the difference in the amount of money I make, if, we assume that USD/RUB and SEK/RUB will both increase 10% over the next time period, which also means that the USD/SEK will increase/decrease 0% against one and other.

Lets also assume that all currency pairs have an initial 1:1 ratio. 100 SEK = 100 USD = 100 RUB.

Mechanism A)

If I buy 100 SEK in the USD/RUB currency pair, my prior understanding was that I am actually buying 100 USD. My 100 SEK are therefore first exchanged for 100 USD. When the value of the USD/RUB over the next period goes up 10%. I sell my 100 USD. But what do I then sell it for?

1) Do I get RUB? Ok, my 100 USD now gets me 110 RUB.

2) Do I get SEK? Ok, my 100 USD now gets me 100 SEK, so that scenario is out.

Then now, we continue with 1). When my 110 RUB are exchanged back for SEK, I should get 110 RUB/(1.1SEK/1RUB) = 100 SEK. Therefore I did not make any money on the shorting of RUB through USD/RUB. Despite the RUB loosing value against the USD! But this can't be true. So how does the underlying mechanism work? My understanding is, and the above example shows, that it doesn't matter if you buy USD/RUB or USD/SEK currency pairs, since what you are buying is essentially USD in both cases.

But I don't believe this scenario is correct. What is then the correct underlying mechanisms to facilitate a transaction where you can make money on shorting the RUB, or as I have been thinking, the increase of value of USD versus the RUB. I used to think that I am buying USD, so it doesn't matter what currency pair, USD/RUB or USD/SEK. But as I write this question now, I am getting a different understanding.

My second possible scenario for how this might go is this:

Mechanism B)

When I "buy" 100 SEK worth of USD/RUB, I am actually lending 100 RUB from the market, selling it immediately for 100 USD, then when the price of USD/RUB goes up 10%, to 110 RUB I sell my 100 USD getting 110 RUB. I then return the 100 RUB to the lender, keeping 10 RUB. I then sell the 10 RUB for SEK, keeping 10/(1.1SEK/RUB) = 9.09 SEK, for a total profit of 9.09%, despite the USD/RUB, SEK/RUB actually having increased 10%. It would also mean that it is better were you can to trade directly in the currency pair you have, SEK/RUB rather than USD/RUB if your account is in SEK. Then you would have made 10% rather than 9.09% without any additional costs of transactions. ( I find this a bit puzzling though, need to think about this. )

This scenario is kind of strange because you are lending 100 RUB, then selling it for 100 USD, meaning that you could also just be lending 100 USD directly, or buying actual 100 USD, omitting the lender, but then we would end up in Mechanism A) again. The lender is needed, so you are never actually buying any currency. You are lending the other currency pair, and buying USD.

Note that I am kind answering the question as I formulate it, which is something I had difficulties doing for myself earlier. It pays to write questions and try to explain them :)

The second scenario would allow for a profit to be made as we can see, and one that seems to be the way it must be done.

But this also constitutes a difference in how some people normally seem to think of trading in Forex, and how the Forex platform buttons usually say, "Buy" and "Sell".

My original idea is that when you "buy" USD/RUB, it is the same as buying USD currency so it won't matter if it is USD/SEK, or USD/EUR, because it is perceived as the net result is you buying USD. It shouldn't matter what currency pair. You might even save the last exchange cost doing.

This is the way people normally seem to explain it, that you are buying USD. But you are obviously not buying USD when "buying" USD/RUB as if you were "buying" a stock. You are lending RUB, selling it for USD, selling the USD later and returning the original RUB.

When you buy a stock, you are indeed buying it. Possibly not even so in CFD' markets? When you are shorting a stock, you enter the lending mechanisms.

However, in Forex currency pair trading, it must be that you are always in the lending mechanism.

It would also explain how despite your account being in SEK, you could make money on going long on the SEK/RUB or "buying" SEK with the same amount of SEK as in your account. You are not buying SEK, you are initially lending 100 RUB, selling it for 100 SEK, making it 200 SEK in your account, and then buying 100 RUB for 90.9 SEK later, returning them, keeping (200-90.9)SEK = 109.1 SEK.

Despite the direction, you are always kind of in the mechanisms of shorting/blanking.

Is this the correct understanding?

Sorry for this long post.

## 1 Answer

Without going into minor details, an FX transaction works essentially like this. Let's assume you have SEK 100 on your account. If you buy 100 USD/RUB at 1.00, then that transaction creates a positive cash balance on your account of USD 100 and a negative cash balance (an overdraft) of RUB 100.

So right after the transaction (assuming there is not transaction cost), the "net equity" of your account is: `100 SEK + 100 USD - 100 RUB = 100 + 100 - 100 = 100 SEK`.

Let's say that, the day after, the RUB has gone down by 10% and the RUB 100 is now worth SEK 90 only. Your new equity is: `100 SEK + 100 USD - 100 RUB = 100 + 100 - 90 = 110 SEK` and you've made 10%(*): congrats!

Had you instead bought 100 SEK/RUB, the result would have been the same (assuming the USD/SEK rate constant).

In practice the USD/SEK rate would probably not be constant and you would need to also account for:

• transaction costs (commissions and bid/ask spread)
• interest rate differential (you will receive interest on your SEK 100 and USD 100 balance but pay interest on your RUB 100 overdraft) - the reference rates used depends on your bank/broker. At the moment, you would receive close to 0% interest on SEK and USD credits but pay around 10% on RUB debit.
• interest rate spread: on credit balances, the bank will pay you (Reference rate - spread), for example, Libor - 0.5%. Similarly on debit balance, they will charge you (Reference Rate + spread), for example Libor + 0.5%.

(*) in your example, the USD/RUB has gone up 10% but the RUB has gone down 9.09%, hence the result you find. In my example, the RUB has gone down 10% (i.e. the USD has gone up 11%).

• Thank you for your answer. It helps clarifying it a bit. You say that it creates a positive vs negative cash balance. What does that mean in layman terms? I buy a 100 USD for SEK? And I borrow a 100 RUB? Essentially possibly confirming "Mechanism B"?
– mjs
Oct 28, 2014 at 19:43
• You borrow 100 RUB to buy 100 USD - SEK is not used in the transaction. Oct 28, 2014 at 23:04
• i am back thinking about this again. the current situation with the russian central bank having increased the rate to around 17% borrowing RUB is now much much more expensive, which is understandable. On my trading platform it is now around 17.5% to go long on USDRUB. But going short is around 14.5% as well. But with regards to our discussion, going short should mean that I borrow 100 USD and buy 100 RUB. What could possibly explain the high interest rate for going short on the USD/RUB now?
– mjs
Dec 26, 2014 at 15:19
• It does not make much sense (I would expect the rate to be 14% positive) but your broker should have an interest term sheet somewhere that explains how this is calculated. Dec 26, 2014 at 20:04
• "I would expect the rate to be 14% positive" - care to elaborate on what positive means? On USDSEK the cost is less than 1% both ways. Why would going short on the USDRUB be affected by the russian state rate.
– mjs
Dec 26, 2014 at 20:39