What is Synthetic
Synthetic is the term given to financial instruments that are created artificially by simulating other instruments with different cash flow patterns.
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."
BREAKING DOWN Synthetic
A synthetic position is taken to create the same payoff as a financial instrument by using other financial instruments. A synthetic position exists if multiple financial instruments are bought that have the same payoff as investing in a share. A synthetic position can be created by buying or selling the underlying financial instruments and/or derivatives.
For example, you can create a synthetic option position by purchasing a call option and simultaneously selling 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 underling 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 his option to purchase the security at $45. On the other hand, if the price falls below the strike, the put buyer will exercise his right to sell to the put seller who is obligated to buy the underlying security at $45. One can see that the synthetic option position would have the same cash flows as the underlying security.
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 income. A bond that pays out regular interest payments also provides an investor with an income 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 product, to safeguard the principal investment, and an equity component, to achieve alpha.
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 position 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.