An ETF that uses synthetic replication and does not hold the underlying securities exposes investors to which risk?

• A. Liquidity risk
• B. Counterparty risk
• C. Inflation risk
• D. Interest rate risk

Answer: (B)

Synthetic replication relies on derivatives to track an index instead of owning the actual securities. Because the ETF’s exposure comes from a contract with a counterparty, investors face counterparty risk—the chance that the other party to that derivative could default or fail to meet its obligations. If the counterparty can’t honor the swap or if collateral arrangements aren’t sufficient, the ETF may not deliver the intended return, harming investors. While collateral and risk controls help, some exposure to the counterparty’s credit risk remains. Inflation risk, interest rate risk, and liquidity risk are general investment risks, but the distinctive risk here is the potential loss if the derivative counterparty cannot fulfill its obligations.