Replication and

Synthetics
 Customization
 Why the urge to customize?
 To get what you need

 What would you like to customize from a

risk management perspective?
 Cash flows
 Examples of Customization
 Swaps for competitive advantage
 Need fixed rate loan but take floating rate loan
 Swap to get fixed rate loan you actually
needed
 View based option trading strategies
 Spreads
 Combinations
 How do you Customize?
 Take a position in an instrument that gives
you the desired cash flows
 What if no such instrument exists or even
if it exists not sufficient liquidity
 Take positions in multiple instruments
such that the net cash flows of these
instruments matches your desired cash
flows
 Replication
 Replicating desired cash flows by taking
positions in multiple instruments
 Positions in multiple instruments
corresponds to a replicating portfolio
 Net cash flows of replicating portfolio
based on addition of individual cash flows
of individual constituent instruments
 Synthetics
 Creation of an instrument synthetically by
a replicating portfolio
 Synthetic instrument has cash flows that
are the same as the cash flows of the
replicating portfolio
 Simpler, liquid instruments used in
replicating portfolio to create complex
synthetic instruments
 Financial engineering – design of
replicating portfolio for creation of
synthetics
Static versus Dynamic Replication
 Staticreplication – positions taken to
create synthetic are taken once and kept
unchanged till expiration
 Dynamic replication – positions taken to
create synthetic may have to rebalanced
 Examples of Synthetics
 Interest rates
 Options
 Can you make a synthetic long call
option?
 Synthetic Loan
 Japanese company wants 3 month USD
loan
 Unable to get line of credit from
Euromarket
 Can create a synthetic 3 month USD loan
 Synthetic Loan (contd.)
 Take 3 month JPY loan
 Buy USD spot / sell JPY spot
 Sell USD 3 months forward / buy JPY 3
months forward
 Cash Flows for USD Loan

+100 USD
t1=t0+

t0 t1

100 (1+Lt0 )

Borrow Pay back

Receive USD with interest
Cash Flows for Synthetic USD Loan
(a) Borrow Yen…

t0 t1
+ Pay borrowed Yen + interest
(b) 100 USD

t0 t1
Buy spot dollars with the Yen..
+ Borrowed Yen + interest
(c)

t0 t1
…Buy the Yen forward
- USD

Adding vertically, Yen cash flows cancel…

(d) 100 USD

t0 t1
- USD
Synthetic Short Position in Asset
 Want to save tax to be paid on capital
gains
 Bought something at 200 and sold at 250
 Could book capital loss by selling an
underlying asset that you currently hold
that has lost value
 Underlying asset originally bought at 100
 Currently trading at 50
 Immediately buy back sold underlying
asset to retain portfolio composition
 Tax authorities may not allow this
Synthetic Short Position in Asset
(contd.)
 Can create a synthetic short position
instead of actually selling the asset
 Sell an at-the-money call on the underlying
asset with a particular expiration
 Buy an at-the-money put on the underlying
with the same expiration
 What is the relationship between the prices of
the above call and put?
 Buy underlying asset
 Cash Flows for Capital Gain

December
$50 Capital gains
September $200

January January
-$200
Cash Flows for Synthetic Short
Long position
Gain
in Zt

zt
Z1 = 50

Loss
Purchase another Z - asset

Long put with

Gain strike 50

zt
K = 50
Short call
Strike price with strike 50
Loss
Synthetic short position in Z - asset
Call and Put Exercise Conditions
(a)
+
If Zt appreciates call will be exercised

K = 50 Z
zt

Receive $50,
- deliver Z with cost $100

Long put Short call

(b)
+ If Zt declines put will be exercised

z
zt
K = 50

Receive $50,
- deliver Z with cost $100
 Funding Requirements
 Synthetic short is risk-free as it is
guaranteed to allow booking of a capital
loss of an amount known with certainty
 Synthetic short is zero-cost as the call and
put have the same price
 Zero funding requirement for creating
synthetic short