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Synthetic Forward Contract

  

Categories: Derivatives

A forward contract simply refers to a deal that executes some time in the future. You aren't buying 100 shares of NFLX now. You agree to buy 100 shares of NFLX in September, at a price of $400.

A synthetic forward achieves the same goal, except without actually involving a forward contract. Instead, you use a combination of puts and calls to create the same scenario, only in a different way.

You want to recreate that forward to buy 100 shares of NFLX at $400, expiring in September. You buy a call contract (an option to purchase the shares) for 100 shares of NFLX at $400, with a September expiration. Then you write a put, i.e. you sell the option for someone else to sell you 100 shares of NFLX at $400 a share, expiring in September.

So...you're buying a call and selling a put. Both have the same strike price and expiration. (You can create a synthetic short forward contract by selling a call and buying a put.)

If NFLX rises to $420 between now and September, you'll exercise your call (the put will expire unexercised) and buy the shares for $400. If shares of NFLX drop to $380, the party who purchased your put contract will exercise it, forcing you to buy shares of NFLX at $400 a share (the call will expire unused). In either case, you end up buying shares at $400...same as if you purchased the forward contract.

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