Synthetic Cash
An instrument that is tailored to mimic other financial instruments used in investment options is called Synthetic Cash. Customization can be done to suit the requirements and purpose for use of large investors. It allows investors to choose from investment options without investing capital to acquire or sell an asset.
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How it is used?
Synthetic cash is tailored by an investor for various reasons. It is used to structure a product or financial instrument that offers a similar payoff as other existing instruments. Synthetic cash is customized to mimic other instruments to form a reliable financial instrument with similar products as others. An investor decides to use options to create a synthetic cash short position which is better and easier than short selling stocks. An exact replica can be made in synthetic cash long positions, where an investor opts to simulate a stock’s long position without actually buying stocks for capital gains.
Products under Synthetic Cash:
Synthetic products are complex as they are custom build created through contracts. They are of 2 types: one that pays income and the other that pays in price appreciation. Some securities straddle a line, such as a dividend stock. For others, a convertible bond is synthetic as it needs to get. Some securities favor both sides, which states that investor gains from the dividend of security while seeing the appreciation of the same stock. Convertible bonds are synthetic products best suitable for companies that have the willingness to give credit at low rates. The bond issuer can drive the demand for the bond without having to increase the interest for the bond. The bond issuer enjoys the benefit of issuing a bond that can be converted to stock which means that the issuer can attract investors who can forgo certain benefits and wait for the stock appreciation. Bond issuer adds certain features to the convertible bond to attract bondholders. One of the features is the principal protection which aims to lock the principal amount from losses. Another feature that is added is to offer more income to the bondholder in exchange for a lower conversion factor which acts as incentives to bondholders and can attract investors into buying the convertible bond.
Example:
Synthetic Collateralized Debt that invests in a non-cash asset with fixed income assets as underlying assets is further divided into smaller tranches that allow large investors to get exposure to different risk profiles.
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Bottom Line:
Synthetic Cash is the term referred to as financial instruments which are engineered to simulate other instruments while altering key characteristics. Often these synthetics offer investors tailored cash flow patterns, maturities, risk profiles, and so on. Synthetic products are structured to suit the needs of the investor.
Author: Urvi Surti
About the Author:
Urvi is a commerce graduate and has a keen interest in Finance. She has completed her Chartered Wealth Management (CWM) from the American Academy of Financial Management and is currently pursuing a career in Financial Risk Management (FRM).
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