Synthetic cash is a financial instrument that is created to function like other financial instruments, but certain characteristics of the simulated financial instrument are altered. The simulated instruments may not necessarily exist.
Synthetic cash provides investors with patterns of cash flows that are specifically tailored to them. It also offers investors risk profiles and maturities that match their requirements. The structuring of synthetic cash primarily depends on the requirements of the investor (s), and it must meet the specified need for it to serve the intended purpose.
Synthetic cash is an instrument that is tailored to mimic other financial instruments used in investment options.
It can be customized to suit the requirements and purpose of use for large investors.
Synthetic cash allows investors to choose investment options without necessarily investing capital to acquire or sell an asset.
Uses of Synthetic Cash
Synthetic cash can be tailored by an investor for different reasons. For example, synthetic cash can be structured to form a financial instrument that offers a similar payoff as another existing instrument. Another reason for customizing synthetic cash is to mimic other instruments to form a more reliable financial instrument with similar properties as other existing instruments.
An investor can decide to use options to create a synthetic cash short position, which is better and easier than short selling stocks. The scenario can be replicated in synthetic cash long positions, where an investor can opt to simulate a stock’s long position without actually buying stocks for capital gains.
Synthetic Cash Flows and Products
Synthetic products are different from synthetic positions since they involve contracts for their custom tailoring for investors. Synthetic positions do not require contracts for their structuring, while synthetic products require contracts, hence making the process of structuring them more complicated.
The main types of synthetic products are those that pay through price appreciation, but there are synthetic products that pay through incomes. Such products are known as generic securities, and they are defined as investments that investors are interested in. Some of the securities favor both sides, which means that the investor benefits from dividends from the security while experiencing an appreciation of the same stock.
Investors can invest in convertible bonds as a form of synthetic products. Convertible bonds are synthetic products best suited for companies that are willing 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 or the coupon payments they will pay to investors. The bond issuer enjoys the benefit of issuing a bond that can be converted to stock. It means that the issuer can attract investors who can forgo certain benefits and wait for the stock to appreciate.
The bond issuer can also add certain features to the convertible bond to attract bondholders. One of the features is the principal protection, which locks the principal amount from losses. Another feature that can be added is to offer more income to the bondholder in exchange for a lower conversion factor. The features act as incentives to bondholders and can attract investors into buying the convertible bond.
The market demand for synthetic cash (and convertible bonds) is on the rise due to its increased popularity in recent years. The demand for synthetic cash is spreading mainly through referrals by investors who are active users. The market demand is shifting from individual investors to institutional investors, especially those that are first-time issuers of convertible bonds.
The new market demand is fulfilled by investment bankers in collaboration with institutions that are offering synthetic convertible bonds for purchase. Such institutions provide convertible bonds with a long-term call option, which gives investors suitable characteristics that they are looking for in such bonds. The majority of synthetic product offers comprise fixed-income bonds, which help to protect the principal investment from losses or volatility.
The products used to create synthetic products can be either financial derivatives or assets, even though derivatives are the most common. By being a derivative, it means that products derive a majority of their cash flows from other assets. Derivatives are, by nature, securities that are reliant upon an asset. As a result, synthetic products have developed an asset class called synthetic derivatives, which are assets in the form of securities.
Synthetic products are considered more complex than synthetic convertibles. An example, in such a case, is synthetic collateralized debt, which invests in non-cash assets with fixed-income assets as the underlying assets. The synthetic collateralized debt is further divided into smaller tranches that allow large investors to get exposure to different risk profiles.
Although synthetic products offer the potential to earn significant returns for investors, they present a high level of risk. The synthetic tranche holders are likely to encounter contractual liabilities, which are not disclosed at the time of purchase.
CFI is the official provider of the global Commercial Banking & Credit Analyst (CBCA)® certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional CFI resources below will be useful:
Take your learning and productivity to the next level with our Premium Templates.
Upgrading to a paid membership gives you access to our extensive collection of plug-and-play Templates designed to power your performance—as well as CFI's full course catalog and accredited Certification Programs.
Already have a Self-Study or Full-Immersion membership? Log in
Access Exclusive Templates
Gain unlimited access to more than 250 productivity Templates, CFI's full course catalog and accredited Certification Programs, hundreds of resources, expert reviews and support, the chance to work with real-world finance and research tools, and more.