Nba694class08 - Equity Derivatives and Related class.8 HOW Investors Use Equity DefiVatives Mark Zu'rack!$WW§‘E%W:MJE.KGJI:~J:4/A’:1= c.‘

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Unformatted text preview: Equity Derivatives and Related class .8: ' - ' HOW Investors Use Equity DefiVatives' Mark Zu'rack October 24, 2006 ';!$WW§‘E%W':MJE.KGJI:~J:4/A’:.'-'-:1=' c.‘ - . .. . During the next four classes, We Wills-focus on how investors use Equity Derivatives. Below are the client types we will discuss and the strategies they follow: I_ Hedging Concentrated Stock [Structured ' - Products " ' r ' ‘ I Hedging Share Crossholdings l Share Repurchase Today we focus on Stock Options Strategies and Portfolio Hedging The strategies we cover today are appealing to most client types but are most frequently used by active managers and pension funds 0609250-Cor-8 4...... l,—-.. {7 \ I/ \I , \: Stock Implied VolatilityVaries Through Time _. 93' Around Events xomwmm PFE: implied and realized volatility - Biggest gaps between implied PW _ i - ' ' '- _m and realized vol happen g ., ; a . : . .2 . a i i when: I The stock made a large move that doesn’t seem repeatable, or i The options market is anticipating a catalyst “Volatility traders” often act independent of fundamentals Jan Ap' --Ju Git ' Jan - Apr" Jul Get ahead of catalysts —«_hfliod\lti(1-Imfl1)----- Rnlizedw Source: Goldman Sachs. 0609250—Cor-8 Knowledge of a Stock’s Fundamentals Helps _ Volatiliw -- WWWK/J’ Equity investors use implied volatility to gauge market expectations I Implied volatility high 9 options market discounting a catalyst I Implied volatility low 9 options market not'discounting acatalyst I The more elevated the implied volatility, the bigger the expected catalysts ' _ Active managers assess implied volatility vsl their own expectations I Implied volatility low relative to expectations 9 buy options . I Implied volatility high relative to expectations 9 sell options Four Case Studies _ who knows Lower WWII- Whfl of] ; I Selling c0veredcalls gym or Owen'an ‘ Buying [311115 to hedge 50M€M€ who Wale: 5"”0k 1040"” j[Im’ldmr‘evn2%:ls“ ojfl I ._- _“H’IC c m 4/ dwelt/9‘ 0 Ida-(11‘ [gaffer d» s/mle ” _l Selling puts - . 4" r“: _ _ I” - _- . J“ I . Mdifi I I. Buying:call._spreads ‘ . “0%an Jiwiamifigmnwmy (MC-wjémwjj 5“" 3 0609250~Cor-S owning mug ——,» turer aflqlhrf W/afilffif S'|_ W Calls -- . - I Covered call selling generates upfront premium in exchange for committing to sell stock at a strike price . ’ .x '73-? '- ‘>"‘"'-gr 1w I Generate premium on range-bound stock fOr committing to exit price I Ideal candidates are long—term holdings where an investor expects limited upsidebefore options expire or those where an investor has a target price to sell _ I Only makes sense when return exceeds selling stock and Limited nearsterm - buying a new one (ignoring taxes) 8 -_upsid_e, or ‘ comfortable exiting at target price StOck View Types of Calculation Are yOu being paid enough to justify the opportunity cost of cappingupside? Leverages the views/price targets Of fundamental equity analysts Volatility Question Why bother with options? HOW iv:an earned "or 5+3?le 1 wh‘Hefi-S - - a '5 Manama Pfica doasnr‘lg Chqflja (lower 0.} 34191;}: Prue, because out o‘r’ W n53 Vt Selllhj mwf'ha-monerq of, Hon jeawllg fill/£3 mow. d-ownsldtfi FN'l'Bchr) I Selling covered calls: brings in upfront premium in exchange for committing to sen; generates the biggest premiums when volatility is highest ll Implied volatility Was extremely elevated (to multi-year highs) because of hedging from credit-related trades,- uncertainty about fundamentals II. Investors who continued to hold. the ' stock could have soldcovered calls for . attractive break-evens implied volatitliy, 6 mo ATM _ 52-week high ' ‘ 53.8% _ 52-week low 207% “we-Wmupwmvwmvm Source: Goldman Sachs 0609150—Cor-8 *\ f Cervelqti‘en beta/veto stock anal H'r C135 Market ing: GM i__ w r i. m» memwmmmwxafivfimfla'my GM Implied Volatility-and cos i——1;6Au92004——. ‘ —16Au92005-i' Sep Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug f— GM 6-mth implied VOI .— GM 5Y CDS Return to % OTM Dividends Exercise 20.0% +. 3.9% 20.0% + 3.9% Note: Assumes stock price same in both cases, 1 dividend payment between position initiation and expiration .-’ \ Synthetic Yield Enhanced Securities Exec! (“grab $m’1fi5 t.“ Pink-“Pd le'ech‘bn) infill Comfmri . Synthetic YES Notes are securities whose economics are equivalent ' to-owning a stock and, being short an 'out of the money call _ Aw:-I-..e-«A..! mum.- :7 ad‘wA-‘u mamasmm;mfrwe-mmmewzm=«a.xv :-,:-.,:>.- -: ,w.--\- v Note that since YES notes are-sold for the same price as the underlying shares: Note Price PV of Coupons = Price of Call Option _ ' + Stock Dividends Stock Price Sample Termsheet: Texas Instruments (TXN) 6 osogzsom-s Note: Yield Enhanced Security -— a Goldman Sachs acronym. At Morgan Stanley, comparable structure is called PERQs a b 9 w t .. wasmxmafiwarr ea Position Stock View: _Zyprexa patent dispute created negative overhang for LLY stock._ Potential for severe downside if LLY loses-the trial (low probability) .LLY investors could: do nothing and hope for the best, reduce/exit'their stock position, or hedge with options With LLY stock at $68 in early August, October $60 puts can be purchased for $1.70 ‘ M gfi "-3 Investor c'hoiCes: _ _ _ a u v fl w ' y a- 1. Do nothing — . a . ';-- 1 00A) 30 . . .2 hold stock . . - ' 20 _ §_ ___________________________ ,_ 3. Hedge with I : _ E ; options— -2.5% 7.5% 15""“f """""""""""""" """"""" “g """"""" """""" “T """""""""" 0 BuyOct$60 put Oct ‘ Jan Apr Jul Dct Jan Apr Jul . LLY implied volatility "-I (OTM put- OTM Cain/ATM volatility . IVoIdf-‘ph‘fjj bk“, . [Owen +604 Mama/P _ _ . '70 . é . Source: Goldman Sachs L” '2 {2‘54 g+ (‘70 z. 3 7 (a g / , 0609250—Cor-8 _- Selling Puts to Bring in Premium, Willing at i Levels “fiWWn‘m-fwm 1%“ J: - .r @ Stock View: The stock is unlikely to fall, and willing to buy at lower price if thezstock does fall; Stock has a valuation floor Volatility View: The impliedvolatility (and premium) should be high enough to compensate for risk of a large down-move ' Risk: Bad news (e.g. accounting fraud) could change target entry price; limited upside if stock rallies ' ‘ :Example: With ERICY at $26.60, Aug $25 puts were bid at $1.50.. Selling August $25 puts generates $1.50'in'premium if the stock stays above $25, locking a purchase price of $23.50 ifrthe puts are exercised 8931le Pairs : loitause when Skew ALOV€ #Qrdy, [0/ Unhafargg N] 10ka When flock W“? low, femvl isYEmoucol - ' ‘gr Own-1.1:? {His J’llficrkg ' _. Source: Goldman Sachs OSOSZSDW-B ‘ GOOG: can. Spreads can be an Efficient I Exposuiér Limit Risk c'mxfimfidwzs'rmfiwmnn ;.-. -- I Stock view: Largernove likely; positively biased l "Volatility view: GOOG options expensive ahead of earnings, pricing in a ' 12% move;_volatility likely to fall after the event, eating-up options profits I ' Bullish sentiment created “negative skew” —- OTM calls were more expensive than-puts - I Buying stockor'calls alone exposes investors to potential gap move down BU I—14Jai12005— : —22Jiil2005-1 28 0-20 i—14Jan2005— ; ~22Jtll2005-i 55 a“ 0.15 50 - I. 45 - v — ~ - — - - -~ 50. “fl-.10 40 4!] 0.05 35 ~~~~~ j - - - - - - - - - - - ~ - - - - - - -- :0- 30 eeeee ------------------------- ~~ . --------------- non 25 AAAA — 7.21:; a ——————————————————————————————— . -. ................ - - 00 20 ..... .... --:’.--c..¢:u: . a , n m . . V . . -: .................... --, _____ -- 189 ‘0 05 15. iaaa"-f.i**- “““““ "" """"" ‘5" “~10 , , I I ' Feb Mar I Apr May Jun Jul ' Mar --'- G606 share price . _ _ GODG truth skew kg —GDOG implied volatili —GODG realized volatility- ' _ - - . .s w- '~ So we Goldm S chs 1y ' I ' I OTM Fax— {aw/(KW {Radium/C, . . r -_ _ . .2:- “M u an a OTM {Yd/Q) Md'm higher “fine Ska) A 9 D609250~C0r-8 j thigh/13:7 flax :\/A‘\_\ ‘ __, “a Inverted Skew HelpsCall Spread Buyers _ b A. Expensive I Buying call spreads gives investOrs the best of both worlds: upside stock exposure for lower upfront cost, lower- volatility exposure ‘ VI "Investors willing to limit-upside in-GOOG were 7 well compensated for selling OTMcalls " II- Trading “volatility” no_n'_-_directiona_lly required _ a. 12% stock. move to-break-even Premium paid offset by premium received . ' H -_ 55' in“ 11-July _ Options Prices on 7/22 KQSWMZ #03553?“ foo ' Prices "(post-Earnings, vol -'15"points) when em 0 . t ' ' “ i» . a. « , .. -; . $ $320 >-“ 4 ‘"’ - I '_ $300 Call___ 7 . $13.24 'I $5.84 $16.40 $32.36 $313.24 ' $320 Call $7.05 $1.55 - $6.48 $17.07 $327.05 ' n' ‘ h ‘ n1: -8 Source: Goldman Sachs 010mm émfij? a Lurahj eve 1 10 . ' .A, ‘ -_.‘_ (HI!l ‘ cafi occurs- 8616301 Etpim‘lio'l} wowg 01%er VUWl‘Hli‘j (UPPw on volahiii’j em ev “I Fumhqse 00-91 Sim/Cali fixffirienj in 24-4ij6 ’\_‘V cwnpj {our‘l'itollo of; S‘incllf : oilfo owvy £4”, bicycle flout downside I change risk. (Jet/lucid we: Male/Penal: how mom}: riffi Wlii’lj‘fv lake cm W premium v? Market joey ego, {5°99 muck ‘l-o malice I i n Tficfinj error (wwé'laia‘m i’l'Yk) Joel-wean bet/{3e 4 FOr‘f’rFolio ‘ m" (av-K‘smxma:>3:\:»“’A1L~?.i’vt‘kh.=("1361.51---\ r .‘ Goal: To change the risk in an Equity Portfolio attributable to a decline in the underlying index _ Raising Cash Consideration: o How much initial downside risk are you willing- to accept? Compensated for Limiting Upside - How much outperformancel - .~ do you want if equity markets decline Pay for leltll'lg Downside Only 7 Full Index Participation ' . ._ Within a Range / I 1. 1 o How much underperformanc'e can you tolerateif markets I rally? - ' - » - ' ' - Risks: _ - Tracking error (correlation) Limited downside between the hedge and the Protection fundis aCtual portfolio ; . ' 0 Liquidity impact when creating and unwinding th hedge ' Collar with Higher Upside 7 ' Limit, ReStore Equity= ~‘Exp05ure After Decline 0609250-Cor8 P .u... r, \. 4/ \.2 ’ ‘\ Why Pension-Funds Are Especially u Hedging --- -; flmaa‘mwre-s zen-L: e, .2 Daiggiaghwh Wan mi choed' Benelii The primary objectives of a Defined Benefit Pension Fund are: i I To meet the obligations of the company to make benefit payments to its empioyees I Those obligations are liabilities of the pension fund assets" 'are' “41;”ch _ “I ; Liabilities are funded by the current assets of the pension plan combined with contributions made by __ _ the company _;_ __ _ _ 7‘ WWWNJ‘W 015W“ J“? - - i I Liabilities are heavily interest rate dependent Cover _uV\cJ_€r_‘Furndir‘lj§ II Current assets depend on the performance of the fund A 4; _ , iv 4; I When cUrrent asSets are greater/(less) than liabilities, the plan is deemed to be A /. ffiXaMfolcl. m 0”" “- Wk overfundecl/(underfundecl) ‘Pur'l’lfli‘g ' ' II Pennm {0'04 (:04- #6“? s‘, or hedge I I r I I I To reduce the risk of underfunding, most pension plans rely on asset class diversification “051': Companies are Die-hinted Coanuh‘on plan: .'—--;a defined binepf'l' 44ch more {n Wis/ii: :«ednr _ * Source: Pensions and Investments P&I 1000 Survey, 2006 However, more risk averse plans will hedge their assets and liabilities directly using derivatives 12 0609250-(brb8 gripplig may)? :Mifipficr oloma People who wad-C 900mme exfaomrt 01° Jim)? Mawket: ‘ memufirflfimfiw:ffiw.fli"l‘f’l.":"-4i:',:-::'.{-U ~ _. Pricing Assumptions for all Strategies: ' 1-er13012 = 4.9 _ S&P 500 Div yld = 1.8 1-yrATMImp Vol: 13.5 .. Equity; ' .. Seilingfutures against the portfoliototally insulates Strateg ' its holdings-frommoves in the equity market. As " ' “ ' of February 2006, a futures hedge for one year _w0uld provide the return prOfile below: 1'-yr25-D Call = 11.5 7. SEW": 5—,: — 11.: . 1-yi' 25-0 Put '= 15.55 *5 Li I EXecution ' I Shortfall _ -_— Futures at Fair Value Price estimates based on market conditions as of 2/15/06 #0“) in we “Skew 1:95:95“? 0,0504: wih’lfoowiani— . Selling Jr‘ui‘urt; confwflo‘t : 6M8 jaw, M Imfiflom GEES—9f is? . 'gdfn Vat“: ..._,_ no. Imarkfit Tums-Fate fixed mom.» I I; would FMHDIEU 0F Jiv'oks' amol 'iotahmy Wyn” _'?4S¥Mai o7? :Jefld‘ivolcs 4W“? maSJQMiy :PWf—Fohb {Idol/)3 emcfl} : 113' "My. CMZ . . . . 13 flat m x/ W Masaofion cart (usual? havaEw fiscal] «,thsfbcfc 605‘“; ht- \| 0609250-Cor—8 (er like do it {Lo Cap-Are «{pha/ avoid am»; fewer rut-7v vv ‘WIMVWASL‘AZiFM'-k£mfl§9yfi(€,figama(u Jr"; we,» .,,-,, -\ . 77 _ Index = Writing calls provides immediate income to a portfolio _:':»equit,,_;._ _ Strike = 105 - strategy " providing sOme buffer against market decline, A5 of Volatility .-_- 13 1 '- A ' February 2006, a 1-year call could be structured with the I following terms: ' ' - - Int. Rate = 4, 9 Div Yield = 1.8 Call Price .-= 4,3 Catalan/if (951-11456 (‘ng ‘5 Premium + an 'Cfierffilia cioej- “Gigi-7. Wing. our—11's all: letl’E’wi mt Jellimj ‘Ri‘J'UI/ej? I? Jamil. gqg Mm wlos‘l‘olfi' is 41% Mariner 1 VOlami'hj {3.1 because 57am“? a? 44” mane} OTM cal/L w] 219% W Market MUS": MGV€ 65170 +0 [05.9 Monela, ' ‘ - I r 9 44m}? 0609250—Cor—8 ’5’”, OHS I a __,' 0,03 : a : {qr STOCK animal (skew Sag ______..—-—-‘-'-‘_‘ ~---—"‘ 7 V . a}; 0,;5 [35. 05+ :2 [Bil 14 _ - ' Strategy Strike = _ l - Volatility = 15.1 Interest Rate = 4.9 Div Yield = 1.8 PutPrice = 2.8 Flour : "5 ’Q-cfilm? Result __ _ 3.x elm/ideal jiuoli 5.4%.; IPWl.’ forfco WW bah/994 Fool» Price and Diu Vie-1d! need in Maker}? T‘l’I/‘l-l-SI outta/taco +9 break elm ' ‘ Volami ‘ _ .. - [5,] 5 (0.5433). 2) + 135’ 012/5 0609250—COPS Purrue HMS JMHJ? l a... -a. w-v mfimzeranzu-mrmmww u:- r Mex-xxx??- 14%»: - - ' Buying puts limits doianside riskwhile allowing the portfolio to benefit from market appreciation. As of February 2006, a 1-year put could be structured with. the following terms: WW mammzmywwtw: m—mzm :.< Zero Premium Collar ("em anew) ho Home when, 0J8 H‘rj C4113”!an 774.3“ Proficky downside. fan {TC Hén do Ensleaot mo PM to wow! “fob/Unis “W” A zero-premium collar involves writing a call to finance a long put. As of February 2006, a _1-year zero-premium collar could be structured with the following terms: vamifig 1a-: Rm; Index = 100 Strike = 108.5 Volatility = 12.3 Interest Rate = 4.9 _ Div Yield = 1.8 05-033; 51.?— C .. ' Strategy _ Buy Feb 07 95% Put I Sell. Feb 07 108.5% Call Call Price = 2,3 Upmde Capped..de 852, +0232, 5(03 7“ . . 4:0!“ «PS?- [fl mane? fnCC We}... downside, {Quit Max-lo” WWW”) (Md? Lea- giWEj up fl: “FSlaé,(:£"0-rlomt4- meal +9. [9043 (Afiéwnt mt) New. willie/512' ‘lv gul— l’hg' eon/tot“ soil/[troll Q5 may-W doe: “0111933) clonalan yield g7; mah'Ld— mm: “1,; W (00% .10 g 20.37. (103%?- i’hfirke-F gee: 010,- [racket-1 twof— 97,3 (lac/‘Hcr'foa-Ho’i 1 6 OGOQZSO—Cor-S CORN/"+36! Pomlf‘lghb VF Sibtjd/ @LOW "meani Caf 0‘? 3"” 0M? Collar as amour.le Sellg‘nj lid—um: ? W 03% Upside} rust-Bari o‘F vcul‘wcfl Carpecljtuli av!“ SWZ 'WW ism - '. :wmwmh-W- Index = - 100 I Combining'the purchase of a put with the sale of a put strike = 80 further out—of—the—money. As of February 2006, a 1-year put spread could be structured with the folloWing terms: Volatility = 17.0 Interest Rate = 4.9 __ _ I - 7 _ 0 _ Div We“ ____ 1'8 ' . ' - 5% W h—a Buy Feb 07 95% Put Put Price = 0.45 WI): 1. : 3’5 ms _ I . i7 ’17 A zero—premium put spread finances a 'put spread with a Index = 100 short call. As of February 2006, it could be constructed Strike z _ 110 with the following terms: Volatility = 11.9 K ‘ ._ Interest Rate = 4.9 Buy Feb 07 95% Put - - ' - Sell Feb 07 80% Put :- 1, . D” we", _8 - - Sell Feb 07 110 Call Price = 2.35 1%15 Diff—fed of i'EjM/ar Wag”; far-emi'um caller Cur higher alas-{ck b9 sacrifiqjj cé some. dorwrrlde ' Pm’l'td‘iovw 18 0609250-Cor-8 MSW-8 * Dividend Yield = 1.6% STRATEGY BUY SELL Premium stragtégiefi ‘ u.- «w w M" mmemmézme One Year After Hedge ' 'Zem '. _ - _. _Wr_iting Buying -'Premium Put . _ .Futmfes . _Calls_ Puts - Collar_ ' __ Spread .' R0” 105% Can 103.5% Call 30% Put Month 2.35% -15.55% -5.55% -5.55% . 95%2-put Put Spread Collar_ ‘. ; 80% Put 110Wo Call 19 kafi’ vi‘tw ‘infimences inn/J 3w [nede OSOQZSO-Cor-S Strategies are Often Linked to a Stock or Risk Management Needs --— ’ rmmmmxwxuwmwmw yfi'gf‘rhugyg.V';u.,.‘ 3 If: .- I. _‘.. Market '72 f DO Do Nothing Nothing Sell Do Nothing ' BUY "Sell Puts 20 ...
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This note was uploaded on 09/25/2007 for the course NBA 6940 taught by Professor Zurack,mark during the Fall '06 term at Cornell University (Engineering School).

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Nba694class08 - Equity Derivatives and Related class.8 HOW Investors Use Equity DefiVatives Mark Zu'rack!$WW§‘E%W:MJE.KGJI:~J:4/A’:1= c.‘

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