What it means
Financial instruments are building blocks. A share, a bond, an option and a loan each have a pattern of gains and losses.
By combining them in the right way, you can copy the pattern of a different instrument, and that copy is called synthetic. The classic example uses options.
Buying a call option and selling a put option with the same strike price and expiry date gives a payoff that moves one-for-one with the share price, just like owning the share. The two sides of the trade together are a synthetic long position.
Synthetics can need less cash up front, avoid restrictions on short selling or owning an asset, or be cheaper once costs are counted. A fund that is not allowed to hold a foreign share directly might use derivatives to get the same exposure.
Banks use synthetic structures to move risk without selling the underlying assets. The idea is rooted in put-call parity, a relationship that links the prices of calls, puts, the underlying asset and the interest rate.
When the relationship breaks, traders can profit from the difference, which in turn keeps prices aligned. This is the basis of arbitrage, the practice of profiting from price gaps between equivalent positions.
The risks are those of the pieces used. A synthetic can add counterparty risk, margin calls, complexity and costs that do not show up in a simple comparison.
In the financial crisis, complex synthetic structures amplified losses because few people understood what they were really exposed to. Documentation and accounting also change when a position is built synthetically.
Each leg of the structure is a separate contract with its own valuation, collateral and reporting needs, and auditors will want to see how the legs fit together. Finance teams should therefore record the purpose of the structure, the legs involved and how the combined risk is measured, so the economics of the whole are visible and not hidden in the parts.
In practice
Real-world examples.
Example
A hedge fund wants exposure to a share that is expensive to borrow or hold. It builds a synthetic position with options and ties up much less capital than a direct purchase.
Example
A multinational uses a currency swap and a loan to create the equivalent of a foreign-currency loan without borrowing abroad. The treasury team compares the all-in cost with a direct bond issue before deciding.
Example
An investor in a market with restrictions on foreign ownership buys a derivative that tracks a local index. The structure delivers the returns of the market, but it also exposes her to the bank that issued the derivative.
Formula
Calculation
Synthetic long share = Long call + Short put (same strike and expiry)
Suppose a share trades at $100. An investor buys a call with a strike of $100 for $5 and sells a put with a strike of $100 for $5, so the net cost is $5 - $5 = $0 (ignoring interest and dividends).
If the share finishes at $110: the call pays $110 - $100 = $10 and the put expires worthless, giving +$10. Owning the share directly would also have gained $10.
If the share finishes at $90: the call expires worthless and the put costs $100 - $90 = $10, giving -$10. Owning the share directly would also have lost $10.
The synthetic position therefore matches the real share at both prices.Case study
Seen in the real world.
Calder Pension Trust is an illustrative, fictional pension fund that wanted to increase its exposure to a foreign equity market by $50,000,000. Buying the shares directly would have required selling bonds it needed for matching its liabilities.
The investment team compared the direct purchase with a synthetic route using a total return swap, in which a bank pays the fund the return of the index in exchange for a fee. The swap needed only about $5,000,000 of collateral and left the bond portfolio untouched.
In the illustrative result the synthetic route delivered the index return less a fee of 0.3% a year. The trustees noted the extra counterparty risk and required the bank to post collateral daily, so the fund remained covered if the bank ran into difficulty.
Watch out
Common mistakes.
- Assuming a synthetic position has exactly the same risks as the real thing, when it can add counterparty and margin risks.
- Ignoring interest and dividends when comparing a synthetic with the actual asset.
- Using a synthetic structure that the team does not fully understand simply because it looks cheaper.
Questions
People also ask.
Why create a synthetic instead of buying the real asset?
Because it may need less cash, avoid restrictions or cost less in fees and taxes.
Is a synthetic position always lower risk?
No, it replicates the risk of the original and may add further risks of its own.
What is put-call parity?
It is the relationship that links the price of a call, a put, the underlying asset and the interest rate, and it explains why synthetic positions work.
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