Synthetic Forward Contract
What Is Synthetic Forward Contract?
A synthetic forward contract utilizes call and put options with the equivalent strike price and time to expiry to make an offsetting forward position. An investor can buy/sell a call option and sell/buy a put option with a similar strike price and expiration date with the intent being to copy an ordinary forward contract. Synthetic forward contracts are additionally called synthetic futures contracts.
Figuring out Synthetic Forward Contracts
Synthetic forward contracts can assist investors with diminishing their risk despite the fact that, likewise with trading futures outright, investors actually face the possibility of huge losses if legitimate risk management strategies are not executed. For example, a market maker can offset the risk of holding a long or short forward position by making a comparing short or long synthetic forward position.
A major advantage of synthetic forwards is that an ordinary forward position can be kept up with without similar types of requirements for counterparties, including the risk that one of the gatherings will renege on the agreement. Notwithstanding, not at all like a forward contract, a synthetic forward contract expects that the investor pay a net option premium while executing the contract.
For instance, to make a synthetic long forward contract on a stock (ABC stock at $60 for June 30, 2019):
- An investor buys a call with a $60 strike price with expiry on June 30, 2019.
- An investor sells (composes) a put with a $60 strike price with expiry on June 30, 2019.
- Assuming the stock price is over the strike price on the expiration date, the investor, who possesses the call, will need to exercise that option and pay the strike price to buy the stock.
- Assuming the stock price at expiration is below the strike price, the buyer of the put will need to exercise that option. The outcome is the investor will likewise buy the stock by paying the strike price.
Regardless, the investor winds up buying the stock at the strike price, which was locked in when the synthetic forward contract was laid out.
Keep at the top of the priority list that there could be a cost for this guarantee. Everything relies upon the strike price and expiration date picked. Put and call options with a similar strike and expiration might be priced in an unexpected way, contingent upon how far in the money or out of the money the strike prices might be. Typically, the boundaries picked end up with the call premium being somewhat higher than the put premium, making a net debit in the account toward the beginning.
Features
- A synthetic forward contract utilizes call and put options with a similar strike price and time to expiry to make an offsetting forward position.
- A synthetic forward contract expects that the investor pay a net option premium while executing the contract.
- Synthetic forward contracts can assist investors with lessening their risk.
