Synthetic financial instruments are custom-engineered investments designed to replicate traditional financial assets while tweaking key characteristics like duration and cash flow.
Key Takeaways
- Synthetic instruments simulate traditional assets but alter key features like duration and cash flow.
- They offer traders positions without the need to outlay capital to directly buy or sell the assets.
- Typically designed for large investors, synthetic products provide tailored investment solutions.
Understanding Synthetic Investments
Synthetic investments enable tailored outcomes for investors with specific cash flows, maturities, and risk profiles. There are multiple motivations for creating a synthetic position.
A synthetic position could, for instance, replicate the payoff of a financial instrument using other instruments. For example, a trader might create a synthetic short position using options for ease compared to short-selling stock. This principle also enables mimicking a long position without the capital need to buy the underlying asset.
Consider creating a synthetic option position by purchasing a call option and selling a put option on the same stock. Assuming both have the same strike price - say $45 - this strategy would offer the same result as buying the stock at $45 when options expire or are exercised. The call option provides the right to purchase at $45, while the sold put obligates buying at $45 if exercised.
- If the market price rises above $45, the call buyer purchases at $45, realizing a profit.
- If the price falls below $45, the put seller buys the stock at $45, mimicking stock ownership without the upfront capital.
Bearish trades reverse these principles: selling a call and buying a put.
Understanding Synthetic Cash Flows and Products
Synthetic products are built through structured contracts, presenting more complexity than synthetic positions. They generally fall into two categories:
- Income-generating.
- Price appreciation.
A notable intersection is a dividend-paying stock appreciating over time. Many investors trade convertible bonds, featuring a blend of income and potential appreciation. Companies utilize convertible bonds to offer lower-rate debt by coupling bonds with equities, appealing to investors seeking income and growth.
Case Study: Custom Synthetic Convertible Bond
For instance, if an institutional investor wants a convertible bond from a non-issuing company, investment bankers can create a synthetic convertible. By combining bonds with a long-term call option, bankers can tailor it to the investor’s desired characteristics. Usually, synthetic products merge fixed-income components (to protect principal) with equity components (to achieve alpha).
Types of Synthetic Assets
Assets or derivatives construct synthetic products, which inherently are derivatives as well. The cash flows they produce derive from other underlying assets. There’s even a dedicated class of synthetic derivatives reverse-engineered to follow single security cash flows.
Take synthetic CDOs, which invest in credit default swaps. These synthetic CDOs further split into tranches offering varying risk profiles to large investors. They can potentially offer significant returns, but their complex structure also binds high-risk tranche holders with undervalued contractual liabilities.
Synthetic products marked significant advancements for global finance, yet past events, like the 2007-09 financial crisis, highlight the necessity for informed creation and buying processes.
Related Terms: call option, put option, strike price, convertible bond, credit default swap, CDO.
References
- IG Bank. “What are the Benefits of Synthetic Trading for Institutional Investors?”
- U.S. Securities and Exchange Commission. “Convertible Securities”.
