Synthetic assets have long been a mainstay of institutional traders. But now, as finance explores distributed systems and token-based finance applications, more people are gaining access to investment vehicles once only available to professional traders.
Synthetics refer to a mix of assets that mimic the returns of another asset. The returns earned by using synthetics are made possible by using a combination of other financial products, such as options, futures or swaps, which mimic an underlying asset. Examples of such underlying assets include stocks, bonds, commodities, currencies, interest rates or an index.
So instead of getting returns by directly buying and selling assets such as stocks or bonds, synthetic assets derive returns from other investment products that are based on the underlying asset.
To go a step further, say you purchase a call option and then sell a put option on the same stock. What is happening is that you are essentially mimicking the returns of that stock, but without owning it. This is one example of how an investment firm might hedge their risk as opposed to buying and selling the stock. Instead of investing in one traditional investment asset, such as a stock, traders use synthetics that can include multiple financial vehicles.
Traders and investors can incorporate synthetic assets into their portfolio to suit their needs. For instance, they can create a strategy with specific cash flow patterns, maturities and risk profiles.
Keep in mind
Synthetics may be viewed as artificial. Yet they can play an important role in a large portfolio, such as with an institutional investor. For instance, a synthetic position enables traders to take a position without having to lay out the capital to buy the underlying asset. Additionally, traders use synthetics for the following reasons:
- To reduce risk
- To try for stronger returns
On the other hand, synthetic investments might cost more in fees and they involve more trading prowess due to their complexity.
Who trades in (traditional) Synthetics?
Professional traders have historically dealt with synthetics on behalf of big trading firms for institutional clients. They buy and sell options, futures and other types of financial contracts to try and help the firm’s clients avoid unforeseen price fluctuations.
Traders in derivatives constantly follow the markets as they are also constantly vulnerable to losses. One investor may be making a profit by trading a derivative. But at the very same time, another investor is losing money, making derivatives a zero-sum game.
Significance of synthetic products
Since high amounts of leverage are necessary to attain positions in synthetic asset markets, it’s been primarily investment firms and banks that have dominated this type of trading. So most of us have never really had any reason to pay attention to them. But if you take a closer look, you'd be shocked at how derivatives dominate the world’s money and markets.
The derivatives market equaled a estimate of $1.2 quadrillion in 2017. This represented vastly higher numbers than any other type of market, including stock markets, global debt and real estate.
Synthetic investment product: A type of investment using derivatives, meaning any cash flow produced by the synthetic product that actually derives from other assets. Synthetics may also be described as their own asset class.
Synthetic Assets: A mix of assets that, in combination, mimic the effect and value of another asset.
Derivative: A contract between two or more parties that derives value based on the performance of another asset or index.
Types of synthetics
- Options spreads
- Structured products such as a collateralized debt obligation (CDO).
- Certain investments in real estate
- Guaranteed investment contracts