Synthetics

A synthetic is a combination of financial instruments – often two, sometimes more – designed to mimic another single security.

For example, you can combine an investment in redeemable preference shares – which carry a fixed dividend similar to a bond – with warrants giving you the right to buy a company’s ordinary shares. That creates a ‘synthetic’ with a similar return to that on convertible bonds from the same firm.

Why bother? Maybe because the investment you want isn’t available, so you create a synthetic instead. Tax also matters – different securities are treated differently. Finally, you may be able to get higher returns from the synthetic than the mimicked security without significant extra costs.