A synthetic security is created by combining securities to mimic the properties of another security. The security being mimicked may not actually exist.
It is often straightforward to mimic the a security with a portfolio of derivatives that reproduce the returns on their underlying. The equivalance of a cash plus derivative combination to the underlying is most obviously true for a portfolio consisting of cash and a future, but it is also true for other derivatives such as options.
An example that might be familiar to some readers is that a portfolio consisting of a (long or short) position in the underlying security and cash (or debt — short cash) can be constructed which delta hedges an option. This is used to derive the Black-Scholes formula.
Obviously this implies that same holding of a derivative plus cash or debt can replicate the underlying security. Inverting these holdings (swapping long for short), gives a portfolio of a derivative plus cash that reproduces the cash flows of the underlying security. By packaging these together (through a securitisation), a synthetic security is created.
As a simple example of the creation of a synthetic security that creates a wholly new security consider this: the combination of strips and zero coupon gilts to create what amounts to a government bonds that does not otherwise exist.
To create such a security one would combine:
- A zero coupon gilt with the same expiry date as the gilt being synthesised.
- A strip with the same expiry date and the same interest payments as the gilt being synthesised.
One reason for buying a synthetic is clearly to be able to buy a security that does not exist other than as a synthetic. There are a number of other possible reasons, including:
- It may be cheaper to buy the synthetic than the security it mimics, because of commissions, spreads, and the volume that needs to be purchased.
- The synthetic may be superior in some way: it may be less volatile, for example. Unless there is some balancing drawback (which is usual), the law of one price is violated.