Synthetic Financial Instruments: What They Are, How They Work, and Examples

Understanding synthetic financial instruments

In the realm of finance, synthetic refers to financial instruments engineered to replicate the behavior of other assets while modifying specific attributes such as duration and cash flow. These instruments offer traders the ability to take positions without needing to physically buy or sell the underlying asset. Primarily designed for large investors, synthetic instruments are customizable and tailored to suit specific investment requirements.

Reasons behind using synthetic positions

The creation of synthetic positions serves diverse purposes. It enables the replication of the payoff of financial instruments using alternative instruments. Traders often utilize synthetic short positions by employing options instead of the traditional method of borrowing and selling stock. Similarly, they can mimic long positions by using options without directly purchasing the stock.

For instance, in a synthetic option position, one might purchase a call option and simultaneously sell a put option on the same stock with matching strike prices. This strategy mirrors the concept of purchasing the underlying security at the strike price when the options expire or are exercised.

When the market price surpasses the strike price, the call buyer can exercise the option to purchase the security at the agreed price. Conversely, if the price falls, the put buyer can sell to the put seller, who is obliged to buy the security at the strike price. This strategy effectively imitates stock investment without requiring a significant capital outlay.

Understanding synthetic cash flows and products

Synthetic products are more complex than positions, often being custom-built through contractual agreements. They usually come in two generic types: those that provide income and those linked to price appreciation.

Convertible bonds are an example of synthetic assets. They are particularly suitable for companies looking to issue low-rate debt to generate demand without raising interest rates. These bonds offer potential appreciation along with a steady income stream. Investment bankers collaborate with institutional investors to create customized synthetic products to meet specific demands.

Diverse types of synthetic assets

Synthetic assets can encompass both derivatives and tangible assets, with synthetic products themselves being derivatives. For instance, synthetic CDOs invest in credit default swaps and are divided into tranches offering diverse risk profiles to large investors.

The innovative nature of synthetic products in the finance sector has been remarkable. However, instances such as the financial crisis of 2007-09 indicate that not all creators and buyers fully understand the complexities and potential risks associated with synthetic products.

Different types of synthetic assets

Synthetic assets can involve both derivatives and real assets, with synthetic products themselves being considered derivatives. For example, synthetic CDOs invest in credit default swaps and are divided into tranches offering diverse risk profiles to large investors.

Synthetic products have indeed brought innovation to the global finance market. However, historical events such as the financial crisis of 2007-09 have underscored the potential risks associated with these products, indicating that both creators and buyers need better understanding and education about the intricacies involved.

Frequently asked questions about synthetic instruments

What are the primary purposes of synthetic positions?

Synthetic positions are specifically designed to replicate the payoff of financial instruments using alternative instruments. They allow traders to mimic positions without actually owning the asset.

What makes synthetic products complex?

Synthetic products are custom-built through contracts to cater to specific investor needs, resulting in intricate structures and potential risks if not fully comprehended.