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Lecture 5

ADMS 4501 Lecture 5: 4501 assignment

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Administrative Studies
ADMS 4501
Lois King

INTRO Synthetic Exchange Traded Funds or Synthetic ETFs as they’re commonly known are investment funds that trade on the ASX and invest in a basket of securities or other assets that track the performance of a specified index or benchmark for example the S&P ASX 200 Index. One of the key benefits of ETFs is that they provide a low cost way for investors to diversify their portfolios in one simple transaction. When one ETF seeks to achieve the return of the underlying market index or benchmark there are generally 2 common methods for an ETF to track its performance: DESCRIPTION The first method is to invest in the securities of companies or other assets that are included in the underlying market index or benchmark. An ETF which seeks this method is known as a conventional ETF. The second method {DISPLAY CHALK BOARD PICTURE} does not necessarily invest in the securities included in the index or benchmark but rather aims to replicate the performance of the index or benchmark by holding derivative financial instruments such as SWAP agreements or futures contracts instead of the actual securities in the underlying benchmark. An ETF which uses this method is known as a Synthetic ETF. Synthetic ETFs are often used to participate in markets that would otherwise be inaccessible because of illiquidity or inaccessibility such as the European banks which currently have a short ban in place. With a Synthetic ETF, the derivative financial instruments would require the ETF to pay or to entitle it to receive payments so that the return to the fund before fees reflects the performance of the index or benchmark - not the assets actually held. Apart from money owing to the derivative counter party, the remainder of the funds value is generally invested in other assets which may or may not reflect the index or benchmark. By holding these derivative financial instruments, Synthetic ETFs aim to transfer the risk associated with matching the performance of the ETF to the underlying index or benchmark, by doing so Synthetic ETFs aim to more closely track the benchmark than Conventional ETFs. GENERAL INFO Synthetic ETFs are issued by the Australia Stock Exchange, Hong Kong Exchange, Germany (through Deutsche Bank), Switzerland through Credit Suisse, Societe Generale in France, and even in Canada through National Bank of Canada with Horizons ETFs – although they are not issued in the United States. Synthetic ETF’s have become mainstream in Europe, but in North America, they have not been accepted quite as easily by the financial regulators. As of April 2011, International Centre for Financial Regulation finds the market for Synthetic ETFs in Europe is 45% of all ETFs traded, but in North America, there are only two issued. Regulations in Europe regarding synthetic ETFs are much more lax – this is evidenced by the UBS trading loss involving synthetic ETFs of $2.3 billion. In total, the synthetic ETF market is valued at around $195 billion, or 13% of the global ETF market. In late 1997, Synthetic ETFs weren’t created yet, so the growth we’ve seen over the past 14 years has been huge. RISKS Synthetic ETFs are generally associated with many risks due to the nature of the ETF. Counterparty Risk: {SHOW COUNTERPARTY RISK CHART} Unlike conventional ETF’s, due to the use of derivatives to achieve their investment objective synthetic ETF’s are subject to the risk that the counter party to the derivative will fail to meet some or all of its obligations to the ETF. To assist in mitigating this risk, ASX for example, requires each Synthetic ETF to keep the amount of assets owing to the derivative counterparties to a limit of 10% of the NAV of the ETF. If for some reason the counter party fails to honour its obligations to the ETF, the fund may not be able to deliver its obligations and investors will only run the risk of losing 10% of the value of their investment in the ETF. ASX also imposes restrictions on which counterparties ETFs can enter into derivatives with, to try to minimize the risk of the counterparty failing to perform. The risks are greater when Synthetic ETFs are traded OTC derivatives, which are not subject to central counterparty clearing arrangements. Collateral Risk: Theoretically, Synthetic ETF assets and investor interests are covered by collateral. The collateral in one case may note fully cover the ETF’s assets, especially in a falling market. Liquidity Risk: Synthetic ETFs are also prone to liquidity risk. In a case where the provider of the ETF is asked by investors to return cash back to them (redemption), there will be strain in the funding mechanism. in a case When these investors take back large amounts of money due to market events there is also a good chance for funding liquidity risk to occur. The ETF provider may also have a hard
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