This article is rather complex if you don’t have a background in finance. It will discuss bonds and financial instruments and how retail investors like you, end up buying these products. I will aim to simplify it as much as I can as I believe everyone should have a basic understanding of these synthetic bonds.
Lets begin with understanding what a bond is. A bond is a financial instrument that provides fixed income. I create a bond, sell it to you for $5000 for a period of five years. That makes you the debt holder. Within that five years, you get a regular income in the form of interest for lending out your money. And by the end of the five years, you get your $5000 back. Simple enough.
There are many types of bonds. Companies often sell bonds to generate cash if they find the cost to be cheaper than borrowing through conventional means. But what I am going to discuss is synthetic bonds, a type of bond that guarantees a risk-free return.
A Synthetic Bond
- Buy a stock of a company
- Buy a put option
- Sell a call option
1. Buy a Company Stock
The first step is to go on a stock exchange platform to buy a stock of a company. Ideally, you want the stock of a relatively stable company that has a resilient business model with a fairly robust future outlook. This stock will then be subject to a set of contracts. Contract that can be purchased to guarantee a future payoff regardless which direction the stock moves.
2. Buy a Put Option
Buying a put option effectively means buying a contract that gives you the right to sell the shares you bought at a specified price at a specified time. To put it simply, this contract gives you the option to sell your shares at a higher agreed price in an event of a market downturn. For example, if I owned airline shares pre-covid and anticipated a pandemic, I could just buy a put option contract. The contract would give me the option to sell my shares at better rates than the market post-covid.
So this contract has one objective; to restrict your loss if the market goes downhill. So now we have our stock which we are hoping for it to go up, but we are also not so fazed about it going down. We have taken measures through put options.
3. Sell a Call Option
Selling a call option means you are giving a buyer the right to purchase your shares at a specified price and time in exchange for an upfront fee. This means, regardless how the market moves, if the buyer decides to exercise the option, you will sell your shares to them at the agreed price. When would the buyer act? If the shares of a particular company go up too high. Then it would make sense to exercise the contract and buy it from you, who has agreed to sell it at a lower price. The buyer can exercise their contract, buy the shares from you at a bargain and immediately sell it on a stock exchange at market value. Now we have what makes up synthetic bonds.
- If the price of the stock moves up, you get a return.
- In the event of a price drop, you get return on your put option.
- If a buyer exercises his call option contract, the fee paid offsets your loss of selling your shares below market price.
Combine All Three, And you Get a Risk-Free Synthetic Bond
If you combine all three instruments, package it into a financial product, you would be able to sell it as a synthetic bond for a guarantee of fixed returns. Doesn’t matter how the market moves, the instruments tied to the underlying value of the asset will offset the losses. This is called a put-call parity, where if you apply put and call options to a stock, you can offset adverse market movements and deliver a risk-free fixed return. These financial instruments are complex, rare to execute in liquid markets but are commonly practiced among hedge funds and investment bankers.
Synthetic bonds are designed to mimic corporate bonds. When a company sells bonds, they guarantee interest payments originating from their cash flow. When a investment company sells a synthetic bond, they are guaranteeing returns derived from the contracts tied to the underlying asset. These complex instruments played a significant role in the financial crisis of 2008. It began with mortgage-backed securities (MBS), where institutions would sell an MBS and guarantee investor return through the loans made by home owners. Then it went to collateral-debt obligations (CDO), where instead of just mortagages, these CDO securities contained other loans such as credit cards, car loans and bonds. Then it went to synthetic CDO’s. These securities did not derive their underlying value through loan repayments. They derived their value from premiums paid by the small number of investors who were shorting the housing market.
Just let that sink in for a moment
A group of investors foresaw the financial crisis and decided to short the housing market by buying credit default swaps. They were then forced to pay premiums on their position if they wanted guarantee of a payoff. Wall street didn’t see this as a warning. Not only was the premiums not enough for them, but they instead created synthetic CDO’s that derived its value from these premiums and sold them to retail investors. Premiums that were being paid for a contract, in an event of a default of another contract, guaranteed by another contract. Wall street does not know where to draw the line. They call that financial innovation.
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