WHAT IS A SYNTHETIC SECURITY?
A synthetic security is a cash flow stream created from a combination or decomposition of the cash flow associated with a set of instruments that exactly replicates the cash flow streams associated with the real instrument. Through synthetic securities we can combine securities to mimic the properties of another security.
The process of packaging together underlying assets to create a synthetic security is called: securitization
. A synthetic security is also referred to as: a synthetic position
The components making up synthetic products can be assets or derivatives, but synthetic products themselves are inherently (always) derivatives. After all, they are always derived from the underlying assets (or derivatives).
HOW A SYNTHETIC SECURITY WORKS
We can duplicate the cash flow streams of instrument C by combining the cash flow streams of instruments A and B. If they add up to match the cash flow of instrument C, we have effectively replicated instrument C. This combination of instruments A and B giving rise to cash flows that will mimic those from instrument C constitute a synthetic instrument C.
SYNTHETIC SECURITY EXAMPLES
One example of a synthetic security is the packaging together of a swap and a bond to create a floating rate security from a fixed rate security. Another example could be purchasing a call option and simultaneously selling a put option on the same stock.