What risk is associated with synthetic replication?

• A. Market liquidity risk
• B. Exchange rate risk
• C. Counterparty risk
• D. Interest rate risk

Answer: (C)

Synthetic replication uses derivatives to reproduce the payoff of an asset without owning it. The defining risk here is counterparty risk—the danger that the other party to the derivative contract may fail to meet their obligations. If the counterparty defaults or becomes insolvent, the expected replication payoff may not be delivered, leaving you with losses or an incomplete hedge, especially with over-the-counter trades that aren’t centrally cleared.

Other risks like market liquidity, currency movements, or shifts in interest rates can affect value, but they’re not the key vulnerability of the replication method itself. The reliance on another party to honor the contract is what makes counterparty risk the primary concern in synthetic replication.