Synthetic Equity: A Way To Buy Stocks Without Buying Stocks

So, it seems we can now rule out a bad bet on the Swiss franc.  From what we can tell, Adoboli appears to have made highly speculative equity trades, masked as synthetic equity trades, which would be no surprise because they came out of UBS's London-based Global Synthetic Equity department.

Synthetic Equity

There is more than one way for a portfolio manager to increase exposure to stocks, or equities.  The most obvious way is to just buy equities.

Another way is to take long positions in equity futures contracts.  Portfolio managers prefer this latter method because 1) transactions costs are lower when trading futures contracts and 2) the portfolio is able to preserve liquidity because the manager only has to maintain the futures exchange's margin requirement, which is much lower than the total dollar value of the securities underlying the futures contracts.

When constructing a generic synthetic equity position, the portfolio manager uses cash to buy risk-free bonds and takes a long position in equity futures contracts.  If the portfolio manager already has a position in risk-free bonds, she can just add the contracts.  This combination of bonds and futures replicates the performance of the equity without actually having an equity position.  Hence, synthetic equity.

Adobolu's Trades

According to UBS, Adobolu's trades appeared to combine equity futures and cash ETFs.  Cash ETFs are kind of like risk-free bonds.  As such, Adobolu's trades looked like synthetic equity positions, or relatively low risk bets on stock market movements.

However, UBS said the cash ETF positions were falsified.  So, rather than moving with the already volatile stock markets through synthetic equity positions, Adoboli was betting on the markets only through futures contracts, making movements in his actual portfolio much more volatile.

Questions Remain

Many questions remain, including how Adobolu was able to falsify his cash ETF positions.  But even if he actually had those cash ETF positions, it seems that Adobolu would have lost the $2.3 billion anyways because cash is not that volatile.

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