What does 'Synthetic' mean

Synthetic is the term given to financial instruments that are created artificially by simulating other instruments with different cash flow patterns.

For example, you can create a synthetic stock by purchasing a call option and simultaneously selling a put option on the same stock. The synthetic stock would have the same cash flows as the underlying security.

BREAKING DOWN 'Synthetic'

Synthetic products are structured to suit the cash flow needs of the investor. They are created in the form of a contract and therefore given the name synthetic.

Synthetic Cash Flows

There are two main types of generic securities investments: those that pay income and those that pay in price appreciation. A stock that pays out a regular and growing dividend provides the investor with a stream of cash. A bond that pays out regular interest payments also provides an investor with a stream of cash. Both products are used to structure synthetic products. An example is a security that pays out a regular interest payment and also allows investors to participate in the growth of the market. They are generally composed of a bond or fixed income generating product to safeguard principal and an equity component to achieve alpha.

Examples

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 securities that are reverse engineered to follow the cash flows of a single security. A synthetic long position moves up with the stock and is structured with a long call and a short put. A synthetic short stock grows when the underlying stock moves down and generally consists of a long put and a short call.

Another example is a convertible bond, which is ideal for companies that want to issue debt that can be converted to equity in exchange for a higher return. 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. Different features can be added to the convertible bond. 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. Other examples include covered call writing, high-yield bond portfolios, funds of hedge funds and other derivative structures.

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