Synthetic Replication

Synthetic replication is a method used by financial instruments, such as ETFs, to replicate the performance of an index or asset by using derivatives like swaps, rather than directly holding the underlying assets. This approach allows investors to gain exposure to markets that may be difficult or costly to invest in directly. Synthetic replication involves counterparty risk since the derivative contracts depend on the financial health of the institution issuing the swaps.

Example

A fund seeking to replicate the performance of a commodities index may use synthetic replication by entering into swap agreements instead of purchasing the physical commodities.