
Synthetic
Synthetic is the term given to financial instruments that are engineered to simulate other instruments while altering key characteristics, like duration and cash flow. To fulfill this market demand, investment bankers work directly with the institutional investor to create a synthetic convertible purchasing the parts — in this case, bonds and a long-term call option — to fit the specific characteristics that the institutional investor wants. There are many different reasons behind the creation of synthetic positions: A synthetic position, for example, may be undertaken to create the same payoff as a financial instrument using other financial instruments. The call option gives the buyer the right to purchase the underlying security at the strike, and the put option obligates the seller to purchase the underlying security from the put buyer. For example, you can create a synthetic option position by purchasing a call option and simultaneously selling (writing) a put option on the same stock.

What Is Synthetic?
Synthetic is the term given to financial instruments that are engineered to simulate other instruments while altering key characteristics, like duration and cash flow.



Understanding Synthetic
Often synthetics will offer investors tailored cash flow patterns, maturities, risk profiles, and so on. Synthetic products are structured to suit the needs of the investor. There are many different reasons behind the creation of synthetic positions:
For example, you can create a synthetic option position by purchasing a call option and simultaneously selling (writing) a put option on the same stock. If both options have the same strike price, let's say $45, this strategy would have the same result as purchasing the underlying security at $45 when the options expire or are exercised. The call option gives the buyer the right to purchase the underlying security at the strike, and the put option obligates the seller to purchase the underlying security from the put buyer.
If the market price of the underlying security increases above the strike price, the call buyer will exercise their option to purchase the security at $45, realizing the profit. On the other hand, if the price falls below the strike, the put buyer will exercise their right to sell to the put seller who is obligated to buy the underlying security at $45. So the synthetic option position would have the same fate as a true investment in the stock, but without the capital outlay. This is, of course, a bullish trade; the bearish trade is done by reversing the two options (selling a call and buying a put).
Understanding Synthetic Cash Flows and Products
Synthetic products are more complex than synthetic positions, as they tend to be custom builds created through contracts. There are two main types of generic securities investments:
- Those that pay income
- Those that pay in price appreciation.
Some securities straddle a line, such as a dividend paying stock that also experiences appreciation. For most investors, a convertible bond is as synthetic as things need to get.
Convertible bonds are ideal for companies that want to issue debt at a lower rate. The goal of the issuer is to drive demand for a bond without increasing the interest rate or the amount it must pay for the debt. The attractiveness of being able to switch debt for the stock if it takes off attracts investors that want steady income but are willing to forgo a few points of that for the potential of appreciation. Different features can be added to the convertible bond to sweeten the offer. Some convertible bonds offer principal protection. Other convertible bonds offer increased income in exchange for a lower conversion factor. These features act as incentives for bondholders.
Imagine, however, an institutional investor that wants a convertible bond for a company that has never issued one. To fulfill this market demand, investment bankers work directly with the institutional investor to create a synthetic convertible purchasing the parts — in this case, bonds and a long-term call option — to fit the specific characteristics that the institutional investor wants. Most synthetic products are composed of a bond or fixed income product, which is intended to safeguard the principal investment, and an equity component, which is intended to achieve alpha.
Types of Synthetic Assets
Products used for synthetic products can be assets or derivatives, but synthetic products themselves are inherently derivatives. That is, the cash flows they produce are derived from other assets. There’s even an asset class known as synthetic derivatives. These are the securities that are reverse engineered to follow the cash flows of a single security.
Synthetic CDOs, for example, invest in credit default swaps. The synthetic CDO itself is further split into tranches that offer different risk profiles to large investors. These products can offer significant returns, but the nature of the structure can also leave high-risk, high-return tranche holders facing contractual liabilities that are not fully valued at the time of purchase. The innovation behind synthetic products has been a boon to global finance, but events like the financial crisis of 2007-09 suggest that the creators and buyers of synthetic products are not as well-informed as one would hope.
Related terms:
Alpha
Alpha (α) , used in finance as a measure of performance, is the excess return of an investment relative to the return of a benchmark index. read more
Call Option
A call option is a contract that gives the option buyer the right to buy an underlying asset at a specified price within a specific time period. read more
Convertible Bond
A convertible bond is a fixed-income debt security that pays interest, but can be converted into common stock or equity shares.There are several risks read more
Credit Default Swap (CDS) & Example
A credit default swap (CDS) is a particular type of swap designed to transfer the credit exposure of fixed income products between two or more parties. read more
Derivative
A derivative is a securitized contract whose value is dependent upon one or more underlying assets. Its price is determined by fluctuations in that asset. read more
Fixed Income & Examples
Fixed income refers to assets and securities that bear fixed cash flows for investors, such as fixed rate interest or dividends. read more
Generic Securities
A generic security is a newly issued security, less than a year old, often backed by recently issued loans or mortgages. read more
Liquid Yield Option Note (LYON)
A liquid yield option note (LYON) is a form of zero-coupon convertible bond that can be converted to common stock by either the holder or issuer. read more
Options Contract
An options contract gives the holder the right to buy or sell an underlying security at a predetermined price, known as the strike price. read more
Outright Option
An outright option is an option that is bought or sold individually, and is not part of a multi-leg options trade. read more