Creating A Synthetic Security
by Jean-Olivier Fraisse, C.F.A.
Experienced investors know their goal is to maximize returns while minimizing risk. The smaller the
capital invested for a profit is, the higher the return is. Using synthetic securities may reduce the
investment that is required to implement a given strategy.
To describe synthetic instruments is at once simple and complex. A synthetic security is created by
buying and writing a combination of options that simulates the risk and profit profile of a security. To
decide on a beneficial combination, first group several financial instruments—a stock, a put and a call,
for example, buying some and shorting the others—and examine their combined profit and loss profiles.
The combined profiles may emulate the risk profile of another single instrument. The group of
instruments form an amalgam instrument, a "synthetic" security that may be used in lieu of the instrument
it emulates when implementing an investment strategy. Sounds arcane? Read on.
COMPONENTS AND RISK PROFILES
A stock owner benefits when the price of his shares increases beyond the purchase price; conversely, he
incurs a loss when the stock price falls below the purchase price. His profit and loss profile (Figure 1) is
thus the 45-degree line (AB) where C is the stock purchase price (we ignore commissions for simplicity's
sake). A stock short seller's profit/loss profile is the reverse of the stock buyer. His profit and loss profile
is represented by line DE in Figure 1. The short seller benefits when the stock price falls below the
purchase price and incurs a loss when it rises.
Similarly, a call option gives the buyer the right—or option —but not the obligation to acquire the stock
in question at the set exercise price within the exercise period. Obviously, the call buyer will exercise the
option only when it is in his interest to do so; otherwise, he will allow the option to expire. Thus, the call
profit/loss profile will be as indicated in Figure 2. ...