Synthetic Assets: Definition, How They Work, Types, and Risks

What is a synthetic asset?

A synthetic asset is a financial instrument constructed to replicate the economic returns of another asset while altering characteristics such as cash flow timing, duration, or risk exposure. Synthetics let investors tailor exposure—matching specific maturities, cash-flow patterns, or risk profiles—without holding the underlying instrument directly.

Why use synthetics?

• Replicate long or short exposure without buying or borrowing the underlying asset.
• Customize cash flows, credit exposure, or maturity to meet specific needs.
• Reduce capital requirements or gain exposure when the underlying is illiquid or unavailable.
• Create bespoke products for institutional investors (e.g., tailored convertible-like payoffs).

How synthetic positions work

Synthetic positions are typically built from derivatives (options, swaps, credit default swaps) or combinations of cash instruments plus derivatives. They are designed so the net payoff matches the target asset or strategy.

Options example:
* Buying a call and selling a put on the same underlying with the same strike and expiration replicates owning the underlying asset (synthetic long).
– If price > strike at expiry, the call is exercised (gain).
– If price < strike at expiry, the sold put is exercised against the seller (obligation to buy at strike).
* The reverse—selling a call and buying a put with the same strike—replicates a short position (synthetic short).

Practical reasons for synthetic replication:
* Easier or cheaper than borrowing shares to short.
Allows exposure without committing full purchase capital.
Enables precise control of cash flows and risk exposures.

Synthetic cash flows and custom products

Most synthetic products combine a principal-protection element (typically fixed income) with an upside or equity-like component:
* Convertible-bond replication: a bond plus a long call can mimic a convertible bond’s payoff—principal protection from the bond and upside participation via the option.
* Institutional demand for features not offered by an issuer can lead investment banks to assemble bespoke synthetics using existing instruments.

These structures let investors shape income, principal protection, and upside participation to meet specific objectives.

Common types of synthetic financial assets

• Synthetic derivatives: Instruments engineered to track another security’s cash flows without owning it.
• Synthetic CDOs: Structured products that gain exposure to credit risk via credit default swaps (CDS) rather than by owning underlying loans or bonds. They are split into tranches with different risk/return profiles.
• Option-based synthetics: Combinations of calls and puts to replicate stock or bond positions.
• Custom hybrids: Tailored mixes of bonds, options, swaps, and other contracts to deliver bespoke payoffs.

Risks and limitations

• Complexity and opacity: Custom structures can be difficult to value and understand.
• Counterparty risk: Many synthetics depend on contractual performance by other parties.
• Liquidity risk: Secondary markets for bespoke synthetics may be thin.
• Model and pricing risk: Valuation relies on assumptions that can be wrong.
• Systemic risk: Leverage and interconnections in synthetic markets can amplify shocks (notably observed during the 2007–09 financial crisis).

Key takeaways

• Synthetic assets replicate the economic performance of other instruments while allowing modification of cash flows, duration, and risk.
• They provide flexibility—customized exposure, lower upfront capital needs, and access to otherwise unavailable positions.
• Common forms include option-based synthetics, convertible replications, and synthetic CDOs.
• Benefits come with significant risks: complexity, counterparty exposure, liquidity constraints, and potential systemic effects.
• Synthetics can be valuable tools for experienced investors but require careful assessment and understanding before use.