What it means
A forward contract fixes today the price of an asset that will be bought or sold later. It is common for currencies, commodities and interest rates, and it removes uncertainty for businesses that must budget in advance.
Sometimes a forward is not available in the right size, date or market, and a synthetic version fills the gap. The recipe uses two options.
Buying a call gives the right to buy at the strike, and selling a put creates the obligation to buy at the strike if the other side exercises. Together they mean the holder pays the strike price and receives the asset at expiry, whatever the market price has done.
The payoff is the same as that of a forward. If the market price ends above the strike, the call is worth the difference and the put expires worthless.
If it ends below the strike, the call expires worthless and the put costs the holder the difference. The premiums matter.
If the call costs more than the put brings in, the holder pays a net premium, and if the put brings in more, the holder receives a net credit. The strike is chosen so that the net premium is close to zero, which gives the forward price that the market would otherwise set through interest rates and carrying costs.
Synthetic forwards can be useful for hedging and for taking positions, but they carry the obligations of a forward. The short put exposes the holder to a loss if prices fall a long way, and a margin or collateral call may follow.
Treasurers should therefore treat the position like a forward in their risk limits and accounting. A related idea is the synthetic futures contract, which uses the same logic with futures options.
The difference is mainly where and how the contracts trade, and how they are settled each day.
In practice
Real-world examples.
Example
A bakery chain wants to fix the price of wheat three months ahead, but no forward is available in its size. Its broker builds a synthetic forward from exchange-traded options, and the chain's cost per tonne is effectively locked.
Example
A jewellery maker expects to buy gold in six months. She buys a call and sells a put at the same strike so that her purchase price is protected, and notes that a sharp fall in gold would cost her on the put.
Example
An exporter needs to sell foreign currency in a year when the bank's forward quote is poor. Her adviser uses options to build a synthetic forward at a better implied rate, subject to the credit limit of the bank.
Formula
Calculation
Synthetic long forward = Long call + Short put (same strike K and expiry)
Payoff at expiry = Market price at expiry - K
Suppose an airline wants to lock in the price of jet fuel at $100 a barrel for 10,000 barrels. It buys a call with a strike of $100 and sells a put with a strike of $100, with premiums of $6 and $6, so the net cost is $0.
If the market price at expiry is $112: the call pays $12 and the put expires worthless. Payoff = $112 - $100 = $12 a barrel, or $12 x 10,000 = $120,000.
If the market price is $94: the call expires worthless and the put costs $6. Payoff = $94 - $100 = -$6 a barrel, or -$6 x 10,000 = -$60,000.
In both cases the result equals what a forward at $100 would have paid.Case study
Seen in the real world.
Tidewater Foods is an illustrative, fictional canning business that buys 5,000 tonnes of tomatoes each season. The finance director wanted to lock in a price of $300 a tonne but found that forward contracts were only offered in much larger sizes.
She worked with a broker to buy calls and sell puts at a $300 strike for 5,000 tonnes. The net premium was close to zero, so the business paid no cash up front.
In the illustrative harvest the market price rose to $345, so the calls gained $45 x 5,000 = $225,000, offsetting the higher cost of buying the crop. She noted that if prices had fallen to $270, the short puts would have cost $30 x 5,000 = $150,000, which the board had agreed to accept in exchange for certainty.
Watch out
Common mistakes.
- Assuming a synthetic forward limits losses, when the short put leaves a large exposure if prices fall.
- Using different strikes or expiries for the call and put, which breaks the match with a forward.
- Ignoring margin requirements, which can create cash calls even when the position is hedged on paper.
Questions
People also ask.
Is a synthetic forward the same as a forward?
The payoff is the same, but it is made from two options and is subject to option market prices, margins and settlement rules.
Why not simply buy a forward?
A forward might be unavailable in the right size or date, or the option route might offer better pricing.
Can the position make a loss?
Yes, as with any forward the holder gains if prices rise and loses if they fall, after allowing for the net premium.
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