Synthetic Finance

Synthetic finance. Structured finance. Let’s have some fun with it!

The moment has arisen to address the structure. Structured finance entails pooling and tranching financial products (or assets). It can be thought of as the architecting of a reservoir of risk. If the idea of risk scares you, be bold, you are risk, and guess what? You are alive. Basically, risk is on your side, you and risk are one in the same. Lucky you!

Risk, merely assigns a definition to the possibility of a broken promise. A little sad, but then again, everything is an exchange. So, let’s keep moving along…

A financial product is an asset, an entity issues (an issuer) an asset. A financial product or asset, is a security. Think of it as being secure. Pretty simple. A security is a literal piece of paper that authenticates ownership over stocks, bonds, and other investments. Before, we get into this though, let’s discuss types of exchange.

To break it down into a three tier system, we explore the limits of classical exchange, generic exchange, and synthetic exchange, the now of the future; common form: structured finance. Classical exchange is the exchange (trade) of commodities. For example, three oranges for three bananas, or four bananas, etc. depending on the exchange rate. Generic exchange is the exchange of a commodity for cash. Cash is the immediate extension of value that is non-discrete. To be sure, exchange is based on perceptions of value. Always.

Synthetic exchange, or structured exchange, in simple theoretical form is the exchange risk for future returns. We call this speculative activity. It necessitates the idea of the promise of the future and it is the exchange of debt. Just to run full cycle, an exchange, is a marketplace.

Imagine, that there are two issuing firms, (companies that issue debt, as in credit cards, loans, and bonds). These two firms seek returns. Rather than waiting around for the maturity of their “On-Exchange,” simply, exchange transactions to pay-out, they trade their risk (the individual bonds that they have bought from various entities) with each other. The beauty of this design lies in the fact that the bonds mature at different rates. What does this mean? Say, I lent my friend three dollars and he has agreed to pay me back in five days, my best friend also lent her friend three dollars, but he has agreed to pay her back in three days. “Kind of heart,” we offer these bonds without interest. I would prefer to have five dollars in three days, rather than wait for the possibility of five, she offers to exchange our positions, she will assume the bond over my friend and I over hers. Basic. The assets in the exchange between her and me are the risks of each separate exchange. Usually, there are associated interest/exchange rates. In this case, it may be that I pay her one dollar at the instance that her friend upholds his promise, his bond, or the five dollars that he was “sold”. (Since, she didn’t charge him interest and that he will not suffer any repercussions for failing to uphold his bondage, I have placed sold in quotations.) Primarily though, this example is to demonstrate that in a structured exchange, risk is exchanged.

Before this hypothetical trajectory becomes too obfuscated, it is probably best to begin speaking the language of structured finance. To begin, the fundamental nature of structure finance entails pooling and tranching systemic risk. The risk of existing assets are pooled together, transforming the risk itself into the product of this new discourse or market, and are subsequently tranched, or diversified into a tiered structure. Comprehensively referred to as a capital structure, each tranche, generally, junior, mezzanine, and senior, each expresses a different potential to absorb loss against the underlying collateral portfolio. A pool of assets is known as a portfolio. If you find it easier to think in a universe devoid of numbers, I like to imagine each tranche as a valley. As the valleys ascend in seniority as it is addressed here, they grow in width. As the valleys ascend in seniority to which the view becomes senior, mezzanine, and junior, they grow in depth. (Although measurements of width, depth, length, and height are basically arbitrary relations, just imagine a standard geographic valley and leave it at that for now.)

If a numerical universe works for you, look to the table below and click for enlargement.Table 2-Harvard, Structured Finance1

Keep checking back…much more to come later today…especially, if you prefer a numbered paradigm…

1Harvard Business School: The Economics of Structured Finance, Coval et al. 33.

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