Synthetic security

A synthetic security is built, not bought. Combine a long position in a long-maturity bond with a short position in a futures contract on the same bond, and the two together behave like an entirely different, much shorter-term instrument.

The logic: the futures position locks in exactly what the bond can be sold for at the futures' expiry. So a 15-year bond, held alongside a short position in a 3-month futures contract on that same bond, behaves like a 3-month, effectively riskless security — because the price at which it will be liquidated in 3 months is already fixed today.

The workbook's construction (Chapter 22, section 22.5.3): take a long position in a 15-year GOI bond, and simultaneously short a 3-month futures contract on that same bond. The maturity of the underlying bond is 15 years, but the combined position has effectively been shortened to 3 months, because the futures leg has already locked in the price at which the bond position will be closed out in 3 months.

The position is riskless over that 3-month window in the same sense a genuine 3-month T-Bill is riskless — the investor already knows, today, exactly what they will receive in 3 months, regardless of what happens to the 15-year bond's price between now and then.

The payoff for doing this: if the yield on this synthetically created 3-month security exceeds the yield on an actual 3-month T-Bill in the cash market, the investor captures that extra yield simply by constructing the synthetic position instead of buying the real T-Bill — this is the yield enhancement the strategy is named for. As with any strategy combining two simultaneous legs, the risk is that one leg executes and the other does not, leaving a naked, unhedged exposure instead of the intended riskless synthetic position.

An investor wants to park money for 3 months and compares two routes: buying an actual 3-month T-Bill, or constructing a synthetic 3-month security.

Route 1 — actual T-Bill. The 3-month T-Bill in the cash market yields 6.50%.

Route 2 — synthetic construction. The investor buys a 15-year GOI bond and simultaneously sells a 3-month futures contract on that same bond. Because the futures leg fixes the sale price 3 months out, the combined position behaves exactly like a riskless 3-month instrument — and, working through the bond's carry and the futures price, this synthetic 3-month security works out to a yield of 6.85%.

Since 6.85% beats the T-Bill's 6.50%, the investor is better off building the synthetic position — capturing an extra 0.35 percentage points of yield for what is, over the 3-month horizon, an equivalent level of risk. This 0.35 percentage point gap is exactly the "enhanced yield" the strategy is built to realise.

Chapter 22 (Strategies using Exchange Traded Interest Rate Derivatives), section 22.5.3 ("Creating Synthetic Securities for Yield Enhancement"), works through this exact 15-year-bond-plus-3-month-futures construction, immediately after covering regular and reverse arbitrage. Expect a conceptual question on how combining a long bond and a short futures position on it shortens the effective maturity of the combined position.

• A synthetic security is not a new instrument issued by anyone — it is a combination of two existing, tradeable legs held together.
• Yield enhancement only works if the synthetic yield beats the cash-market yield for the equivalent maturity — the strategy is not automatically profitable just because it is possible to construct.
• The riskless quality depends on both legs executing and staying in place together. If either leg fails to execute, or is unwound early, the position is no longer synthetic and no longer riskless — it becomes a naked, unhedged exposure.
• The effective maturity of the synthetic position is set by the futures' expiry, not the underlying bond's own maturity.