nba694class03 - ECIUIty Derivatives f ‘ Products" j...

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Unformatted text preview: . , ECIUIty Derivatives f ‘ Products " _ j, ClaSsB': ' Portfolio Trading] Introduction to Options . Mark Zurack - .. __$eptgmber 12, 2006 I To complete Assignment 1 To continue our discussion on Portfolio Trading concentrating on how Agency and Principal Trades work and their respective costs ' .} To introduce options, focusing on now themarketoperates -’ To discuSs the International Securities Case -0607221-cOr-2;»~7\ - - - . .. . _ a I Customer order is working on a best-efforts ” I' A fund Sells the-stocks in a liquidation portfolio and buys basis. Dealer uses market expertise _ _ the stocks in a purchase portfolio in a principal transaction and multiple liquidity sources to ,. ' which is-executed after'the market closes. The stocks are realize best possible prices for client ' ' traded .at that day’s closing prices minus or plus a I Most effective when immediacy is not transaction spread primary concern - g . , ' _ I The client minimizesmarket impact and opportunity costs in passing transaction risk to dealer. Transactions are priced at a spread off the close Choosmg a__ The goal IS to minimize expected trading cost and commissions which can be estimated for agency programs but known at the time of the trade for principal programs Strategy Trading Cost = Commissions + Liquidity Impact + Market Movement 0607221‘Gor-2 _LIqUIdItyImpact in a PortfolIo Trade - - - Wmm‘eéw III In Class- 1, we discuIsISed Trading CoSts being a combination 0f Commissions and Liquidity Impact. - . I Most Portfolio Trades are executed Over a period of time rather than immediately '1' That is designed to reduce Liquidity Impact I In some cases, the portfolio is subject to market risk as a result ' Liquidity Impact Across ExéCution Horizons --Liquidity Impact IrI cents - - II Execute order Immediately _ . ISiIiIce Order Into ten pieces, I- ' _- Execute ov‘er. one hour I Execute ten slices over four hours 1 hour ' 2 hours 3 hours 4 hours Time to Execution 0607221~C0r-2=,"-‘\ ’A‘\ +_ Ma ovement -: :mun ME: "I As a res'ult of spreading oUt the'execution'of a portfolio over time, the investor may be subject to stock market movements :Balancing Liquidity Impact Cost ancl the Expected Market Movement Cents 20 I ' " Expected costs are minimized with execution horizon of 1 hour ":15 1% Expected Liquidity Impact ' I Expected MarketMovement -- Expected Totai'cost ' . 1mm 2 15min; i 30 mm: 45 rain I i'1h_ou_r 4 2"h.ours,'" .3rhours ' 4hours 5h’ours Shours I _Time to Executidn ' Before the market opens, what is the best estimate of market movement that day? 0607221-Cor-2 mm... WWW Impact on __ _-._. _. Market Investor Strategy - Movement Investor wants to Depends on _ buy/(sell) 'expOSUre to futures Qnefsldeid “ the equity market- ‘ Investor wants to buy a portfolio and sell a 'TWOI-Sid'ed' I different one ofe gua I - value (_d-fi " Note": Some portfolio trades are a Combination of one-sided and two-sided trades 0601221—Cor-2/9 u vs Two Sided Trades PrmCIpal Trader - ' Strategy Hedging oVerall market risk by establishing a long/ (short) futures pogfion No market risk, one sideoffsets the other 0507221‘C0f‘2 . Example The head Of a pension plan decided to Shift $500 million of her fund out of value StOCKs into grthh stocks. The growth portfolio she is buying is based on the Russell 200 Growth Index, the value portfolio based on the Russell 200 value Index - s-taton '- » '_Ho.4w_ Should She exchte’the transitiOn agency or principal - How much will itcost? ' 'l Identify stocks that can be transferred from One portfolio to another3 ' Process . - I. Based on the liquidity of the portfolio, estimate how long it will take to complete the trade ' I Estimate each source of cost, resulting in an overall estimate of the cost of trading as agent $m’W-xW‘MXuRN‘rr- . , Pinalytics Portfolio Summary ' I Risk Summary _ - Tracking Error (Relative Risk) If GS Trajhsaguo'n cost-(bp5)*j*,' ' ' ' ' / * 21 day on a Single-stock basrs.‘Va1ue-werghted on a portfolio basss. 70% adjustment for NASDAQ stocks * Annualized over 252 days ** Predicted. Based on Goldman Sachs Program Trading transaction cost model ' ** Over half total capital *** Over total capital. , - ***'* o'v'er total shares vol mm B . ‘AD.V"W>°<‘.’“8€ *1? ._ * ' 21 day median on a single-stock bass. Value-weighted on a portfolio bags. 70% adjustment for NASDAQ stocks 0607221—Cor-2/4" .-\ K“ 0607221'C0r-Z 1 “2'. Questions and Answers aw»; zwwn w. What Is the dollar amount of' in- -kind crosses between the portfolio she is buying versus the one she is selling? . ':'Answer-: 86,884,651 Assuming the GS transaction cost estimates measure liquidity impact ~ of trading-no more than 10% of- a stock’saverage daily volume over a day, what is the estimated liquidity impact of trading the portfolio ' in Cents per share, basis points and dollars? I ' Answer: 26 bps x $33 65: 8. 75¢ x 24, 552, 026: $2,148,057 Assuming the broker would change a commission of 2¢/share, what are the estimated total cost of- trading in Cents per share, basis points and d0liarS? ' ' ‘ ' r ‘" Answer: Commission's ”=‘2¢ x724,552,026 '= $491,041” . Total Costs ' = Liquidity Impact & Commissions = $491, 041 + $2,148,057 = $2,639,098 _ - 7 = $2 639,098 / 24, 552, 026 = 10. 75¢/share ' How long will it take to complete the trade? Answer: Less than 1 day , ThePrIcmg of PrInCIpal Trades .-I u .mmylynrw A”! Total tra'hsaCtion costs of'a principal trade are simply the spread: 'PrmCifiaI Spfeadr- : Commission + Liquidity Impact from Reba/ancmg +_/-‘ Hedging Cost 4- Tracking Risk Premium ' quUidity Impact frdm Rebalancing The dealer’ s estimate of its poSt trade rebalanCing COSt. This cost depends on how much of the trade offsets exiSting positions in thedealer’s book, the liquidity of the trade, and the turnover in the dealer's b..ook That the dealer need not trade all shares in the market to rebalance its book is the essence Of cost savings for principal trades Hedging Cost While rebalancing one- -sided trades, dealers usually use futures to hedge market .risk. Depending on whether futures are overvalued or undervalued, that may ' create a cost or benefit Tracking Risk Premium The amount of spread required'to Cover this risk depends on the risk aversion of the trader . . Liquidity+ Markefi Commission + Impact Move I . Compare vs;- -Agency Costs , _ ,r‘, . , 0607221 Cor r; \| 3/ 0607221-Cor-2 9} in a one- -sided trade, the dealer must offset his/her market risk with futures . .. r-If-I' the dealer IS buying/(selling) a portfolio, he/she will offset market risk by selling/(buying) futures --- -- . If the dealer' IS selling futures, he/she is helped/(hurt) if they are trading above/(below) fair yalue, and the reverse .j..Hedging'j'COSts, for a tWoési'dedj trade are zero _ _ 10 0607221-Cor-2 fr...“ those periods in a year WandPricing Tracking Risk In both, one— and two-— sided portfolio trades, the trader takes the risk that the portfolio and index are not correlated " That risk is commonly known as Tracking Rlsk and is defined as the one standard deviatiOn difference between buy‘ and sell portfolio in a two- sided trade, and betWeen the portfolio and the index in a one— s-ided trade. Althbugh often ouOted 'on‘a'n‘ann'Ual. ba5is, it needs to be converted to a time period consistent with When the risk exists; That is done by taking the annual number and dividing it by the square root of the number of B? P“ 3“" (”‘3’ Tracking Risk should be measured over the period of time the portfolio still has correlation risk, that is before it has been rebalanced y_O'ften,,z people refer-to VAR to measure risk. VAR is often a two standard W deviation measure of risk Most traders build in a Risk—Premium to cover Tracking RiSk 1'1 wmpl —Additional Questions . _ 1.. If you were a portfolio trader at Goldman Sachs, how would you " ' fl. -. price the trade if you assume yOu only need to rebalance half the ' pOrtfoIio, the cost of rebalanCin‘g is consistent with GS transaction ' cost estimates and you are trying to earn 20% of the one standard deviation tracking risk taken on? Answer: ' . - - - Price = Commissions + Rebalancing Cost ...+ Hedging Cost + Risk Premium ' .' ' *I‘bfa}? nsl; = $491 041 + (2,148 057 x 50%) + 0 + (-2 700, 059 x 20%) -—$2105081 MW -- I __ [(mnSachtmwSt) ' 2 Which strategy should the client select? A7“? of‘ pnMayJ 7 Tout M'CMM P““UI°WQ hack Cost 12 0507221-00r—2 0607221~CDr-2 How Premium . is Quoted Strike Price Intervals ' Option Class .. 7 of Options :- . WWNJ 100 shares of the indicatedsecurity The premium'is always guoted on aper share basis. The - option buyer pays the premium to acquire the option. The Seller of the. option receives: the premium... For exampleyin February,‘ an 'XYZ JUL 50 call Option might have been traded at-a premium of 131/2, meaning the seller of that ' option would have received $1,350 for one option contract . covering-100 shares of. XYZ I ”-1.:ExerCIse prices are CUrrently set at 21/2 point intervals for seCUrities trading under $25 5- -point intervals fOr securities trading abbve $25 and belOw $200 and 10 point intervals for securities above $200 All calls and puts-Covering a givens'tock' '13 (w Oprah .. mt enli’rlecl x, mama 0607 ZZI-COr-Z “1550f Options (Cont) All options 'df’the Same-class having the Same exercise- price and expiration date. Thus all XYZ MAY 40 calls would bean individual series . ' r Option Series American vs. " European . With an American Option, 'on any trading day until ExerC'Se - " expiration, a buyer can do one of three things: - I Sell the call back at its current price, thereby canceling the pOSition ' 7 .III ' Exercisethe callto-receive. the underlying shares _ _ :7 Continue to hold the Call ' 'If the Call is European, a buyer can only do 1 and 3 before expiration (Wifurvrem, Can onl Meade Ii' loaf Can. Sell Il- anj'hme) I Jdaz {not How to Exercise ' .. nan option ,The buyer exercises an option by the properI filing through --"-'his broker of- an exerciSe nOtiCe with the O tions Clearin Corporation (OCC ) prior to the fixed expiration time of the opfion Will—ii Wafer-Led OPH‘MY We” mole”; are Eurqaean Bengali-3. will not Wat is excercI'JC Quiz-lg, 01/ (3411/ III EXCErMSCJ M“ 9126:! “lb LL43 (loaf du/f‘ ”when ) 14 OCC eliminates Grub-{v HSk lam-Idle: Mai/BM, allolafious Jinn? m H" Margin m elation: (In Futures) 1,0111 quht: have unllwutral ril‘k Luger; i—ake ho I’ll—k “3011A what +1433 Pod“ M barf-Hf» does Wan—v "the one 00140 {S aSSle/IE’UL +11% ofolijwhon +0 414;; Olofibn /mlftd0mlv chow” £17 OCC ) , Usually 'i’lnzi’l‘: I'S exerche lee set by broker) Pad—Wu; woke/a? ox ephem- am be [Whittle #135164} JaliWrg, VISK— ‘eXCVCiSC (Mir- FmalcSCSfi'i 0+ Won‘fll). 610/1}: 32} (£th gulf—fl flbHng m pxgojfsof f9 WEE/(Pad 1 ._ V‘i __, echanlcs 0f Options (cont) -.S'hck and CTF ophw; (Men/Han) are qunmqy refilr’d aging?“ . Options expire at 10:59 pm (11:59 pm EST) Central - - -- " - time on the Saturday immediately follOWing the third Friday of the expiration mOnth, regardless of whether that Fridayis a business day. . xercise nOtices are due at the OCC by 4: 30 pm Central time on that third Friday ‘ Expiration Dates _ I .. 'All options trade on one of 3 cycles: January/April/July/October, February/May/August/-November, or ~ . March/JUne/September/ December. There are tWo front months and two cycle months listed at all times for each security 15 0607221-Cor-2 Pg 1% _..._ f ‘ 77’ \ I "warrants: ' Legally-a security like a stock rather than a bilateral contract like a derivative,- though usually has option- Iike characteristics. Settle and clear like equities -~ therefore low cost of entry for brokers, tradable through existing equity accounts for investors _.' 7' SW Market In ‘H’lfi. (18-. 0607221-Cor-2 ' Retail/High Net Worth sea. .\~ i mmmaw w w nt . Structured?“ . I ”Notes” ' Fixed-income securities whose coupon and/or'sfinal - payments depend upon the v return of a stock, portfolio ' of 'stocks, or a'market'index - :. Carporations " Institutions Privately-owned options _ contracts between two parties who agree on the underlying stock, stock portfolio or index, as well as ,. the strike price,'expir'ation . ' ' - and e'XerCIse style Access Option Liquidity Exchans'eiTrade'd - - =-.:;optio'ns . Standardized contracts - traded on an exchange and settled through "a clearing house (Emergjsdlers Jake C’QC‘l Iafliewr‘: crediHL risk OPhbn Oral?“ [an Ice “Ejo'halct’al :4 0L Hock {mote 7‘11?" executed 69‘ PXchmgfi Edam?!” lag} W [41,» must be VECeiwoi (flag orders) at eXchanje fitr‘f .mmwww ~n MarketStructure for Different Equnty Products NYSE - l' I I Exchange Traded I ' Stocks | Amex ETF Index Futures Options _ Convertibles Yes— on some . - exchanges referred .. to as a designated ' primary market igma'ké-markets; I I - - maker"(DPM) .. _ ._ .Lotation When Price then" , Price then , 'flo'or traded, z . Negotiated - time _ time ' price then time Price then “me with dealers when electronic " ' . . Price Price . L -' .. . ; . 'SpeCIalIst ‘ . Improvement improvement ' .. _ Zaorf'f‘epfiilfe” 121:5 partICIpatIon _ over publIc " o'ver public i m rgvemgnt -- - orders orders , p -Floo'r?.;vs,-:.-' _ ,_ . _ - _ _ - . __ . ' - ~- '_ Upstairs Electronic“ _ u - '- - g " r- " - trading desks All five products are fungible, meaning you can sell the product to a different counterparty than the party you purchased it from. By contrast, OTC options are not fun ible 17 0507221—Cor—2 an A (f 1' 7'! 0607221-C0r-2 SEH‘SUL M496 +0 partitipm in Order Haw / “a _ ' /_"\ Thf/‘j «farce; CWSS‘uMGlAEhj EéfiVEEMJITLI’J ' ‘1‘ 7 " - I ‘ ‘ —- n 4 C H i ISE has no ‘Pléai‘; {96* [mar Sfflci'dltsf 4"” 9‘3““ sigh" ISE trawl-6 mc’m MW? com ’3th a 3014? (a orbi'pe A" w I» . . D i "' QCldliS 6/ game.» ‘hr msfiiu and} {-0 gei- +0 cashmers International Securities Exchange Case Study _— _ - Discussion QUGStions “5/ it Mt" -‘””””’"°“‘ W“ QI€CM"'C€‘C"“’T? Until IESE cveai-eolfirefafii [awash/.1“ had “/0 Send order afowax/nfkr 1%0Ple a; #1: How: were Marisa} Maine/S“ @3715“ OFfiZMS 7 Wash}: Md”: flags“) (EH, 9k”) ' WEVQ Caun‘ferpqapfi‘ff m nona’gmfijugk Which client base was the driving force behind the ISE? What" benefit 0,955,15— did they feel an electronic exchange wOuld provide? _ Did other options’ clients support the ISE? Why? What is the OCC? Why is it important to the success of the options business? ' What is the cross listing of options? Did the ISE accelerate the process of cross-listing? Is the ISE structured more like NYSE, NASDAQ or an ECN?‘ Did the ISE fully follow price time priority? ' What has the CBOE done in response to the ISE? What competitive advantages does the CBOE have? 18 ...
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