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nba694class09 - EquityDerivatives andReEate...

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Unformatted text preview: ' EquityDerivatives andReEate Products "WW-"‘7‘": fimfig‘fifiwflfi I mass 9:. . ' "Legal and Tax Considerations in Using Equity Derivatives _. Mark Zurack October '31, 2006 l --‘«- mmflmxfiamfirfis‘m‘m-L: “same:- :.=.=-..- l r ‘ [5 To discuss what typesof investors-hold concentrated stock positionsiand why they should diversify . - - - To describe what restricted stockjis and how it relates to singlestock hedging . ' To explain how the different Equity Derivatives products we have discussed are taxed ' ' 'To show how to taxrefficiently buy and hedgeequity exposure To demonstratehowderivatives can be used to tax efficiently short stock and harvest capital losses - To explain additional tax considerations related to hedging single stocks 0609251-Cor—9 . :‘l \ I / \ = /! \. “fr ‘\ ' /'\ ' . c,- ' WhyManaing The Risk of _ _, I mporta nt Significant wealth is created through the a i And kept through the diversification of concentration of assets... - ‘ '. ' assets._.. ' - . - sum?! [ ' .I i,- ; Nor‘maiizedPrice’fi/Q I Normalized Price (9/0) ‘ “ Time " ' - - I ‘ 'Time 0609251-Cor-9‘ Transactions That StostPos‘itions - ‘Immsfiwmotmfimm—mn: 2-5:": s. E Corporations* . Rule 144 B High Net Worth Individuals fl Endowments ' Private Placement Sale of Division B Corporations* _ a Registration rights Y ‘ - a Contractual issues ‘ 'IPO . I a High Net Worth Individuals a Uhdenvriter’s lockup Y 3 Private Equity Partnerships Rule 144 Merger / Acquisition , m High Net Worth Individuals E Rule 144 or 145 Y n Private Equity Partnerships _‘_Phiianthropic _ I m Endowments _ a Rule 144 N ' Contribution ' ' ' Funding m Foundations . Rule 144 N * Also have Accounting Issues 0609251-Cor'9 ,. tockTo Diversify? - r A V mums. ' 'StOCKis restricted Voting and other noneeconomic considerations 'COntinue to retain exposure to the stock While economic eXpOStJre eXists, inyesto'r does not have physical; ‘ shares. to sell . . - - - - - ’ Realizatiofi of a taX‘abl‘e event Liquidity _ 0609251-Cor-9 M Iricteid Stock? ~ m, ‘ WW'DHE:"“KLTEJ-fit‘wfi Shares that are not freely fungible and have one or more Restricted stock 1'5- of thefollowing regulatory limitations: often a mdely used _ _ _ _ p _ ' y _ fermgfuflafiphf - g - m Holding period requirement before-any sales and :l’jg’rgugtg’; 3’35 . - direct hedging is permitted _ restr’ct’om . ' 3,36 w Volume, mann'erof sales and reporting requirements we — I II . '7 I . ' . fiwflwcfl w a? r Delivery of prospectus. reqwred With sales . l - 1 If} V013,. (registration rights) / ' [01.9, U I _ _ _ I I ' I v garte- a Legend on stock, restricting Its use as collateral Rule 144 stock is themost common type of - i '- restriction, although some restricted stock is received ,r “ ‘ with Other constraints. Insome 144 transactions ' . (non—affiliates), the restrictions lapse'after a period of _ - time, in other'cases, the restriction is permanent @101” _ Wow *1; I I ' , \fwgqivg ‘W ' (1% w _ - . In addition to regulatory restrictions, a stock can have ‘ J" .3: "W ‘ ' contractual restrictions, including blackout periods and - - _ trading restrictions - L f \ I ' ': ' - /-\ Types of 144 Stock Transactions x/(‘M‘ WW a ‘ 64 gr [@Mi”? W W9M Can sail? B- ricingpateh _. . Lockup Exnires 4 S. U .d .t r, i / _ 1“ Year '2nci Year 19“ n am" e 5. - ' -- 3 Mama " An'niversa '- Anniversa Lockup Agreement ,- -3 I i" 6 / was 9 _ w. w 7 no’hdghe Com 2nd Year Anniversary Closing Date Reporting company for 90 days a No public Information reqmrement 1-year holding period for all shareholders Se'ller'must be non—Affiliate for at least three months I. a Volume limitation equals the greater'Of 1% of the ‘ a ‘No volume limitation outstanding shares or the average weekly trading volume, - v _ during thepreceding._four- calendar weeks I can 30!“?It a" N6 sbfidtatiofi if. a - 1 a No filing requirement With the SEC 0609251—Cor—9 ' i . 1' Epic/{9' .- arms (iv ‘ - - .r Um“- efl aim” Company Insider (Am-irate)“ 7m- were _ r . (if? % gm Doom. CQnsiderations m- Section 16 W E“ m _ * _ -. . ._ - 6W“ a InSIders of a company must file reports (Forms 3, 4) w 530% - disclosingequity interest and changes in interest via salesrn'fi'fiwg ‘options and other derivatives [Section 16(a)] Any profit byan Insideerrom any purchase and sale, or any saleand purchase, of equity securities of the-company ” . ‘ (inClUding'purch'ase and sale thrOugh'a'de'r'iVatiVes position) within any six—month periodis disgorged to the issuer r _ [Section 16(b)] ' ' ‘ ' An Insider is prohibited from selling short any equity security ‘ ‘of the issuerffor more than-20 clays. Includes short calls and long puts on-more shares than the Insider already owns ‘ [Section 1.6(c)]' ' * ' ' W9" * 1“ HEW zap ' a . “- w- ‘ -- . , -- fl fix/,0! firrfioréi J flow/roux- 6’Cmg M § WM _ Mound Qitrteamezrvw’ ’ {:6 JV 060915 L-Cor-Q {_...\ l 4.\ . ’ ...‘ \ " ew‘. i "w~' . . \' WM:./A\l - ' ._’—\ « “Faxed w I Tax Treatment: ‘ ‘ ' gm. The purchaseof a stock‘does not triggera taxable event ,3 _' Gain or loss from the sale of a stock held ferone year or less : generally'is short—term capital gainor loss, while-gain or loss j__ _' from the‘sale of a stock held more than one year generally is "long—term capitai gain or loss ' _ aft Dividend distributions are taxed as dividendi‘ncome ;.TaxTreatment: I'm “A Short sale is really the customer’s obligation to deliver shares ' to its broker; the short sale is closed, and a taxable event i occurs, when Customer delivers those shares. ' e a The short sale of a stock does not trigger‘a taxable event "short-term capital? gain or loss : ea 'Gain or. loss from c0vering‘fa' shortstock position is always. a The rebate received on a short sale is taxed as interest income OGBQZSl—Cor-Q - Certain U.S.Federal Tax Rates Generally Applicable—mina, \-. to Different-T es ofInvesm n Inc . fix me mmxmewxamfnurzmiemu-ma1-.“ --'-~= ' ewe .- ._i... a::u.l'u-.-u.l' l—_'_—"'—._| 35.00%, .' 35.00% _ .N/A Generain deductible 1 against UBTI (see fn) Generally deductibie . Generally deductible ; r I - -- - -- V ' 7' to the extent of r '9 ' _ 2 5 Investment income I i I . - , ' . . - a) US. persons only. Owner of mutual fund is not treated as owning shares held by the fund. .fii Fla} Includes industrial corporations, banks, and insurance companies, although banks and insurance companies are also subject to ' ' special industry-specific rules. 7 c) Penswn funds generally are tax exempt, but iike all exempt entities they are subject to tax on “unrelated busmess taxable “a , income” (“UBTI‘”), which includes income from activities unrelated to the entity‘s exempt purpose, such as manufacturing, and a ' portion of any income from debt-financed property, such as securities purchased on margin. , .l _ ’ _ - '- H d) Mustbe paid out of earnings to receive preferred tax treatment a} subject to complex limitations, U.S. corporations generally may. effectively exclude 70% to 100% of dividends from income by claiming a “dividends-received deduction." In addition, dividends paid to a U5. reopient in respect of non-[3.5. shares may be subject to withholding at source. Such withholding may be sUbject to reductionjmodification by applicable tax treaties. - 9 ' ososzsmws f/ \ I I/J—.\r I AM ‘ u -‘ .5...- .. . ‘ -. :1 rut/«Dumb? (9: PM?! in LETC‘U) Taxatigfim Exchange Traded and J”- S _ mad? ma arm. Tate @131 “I Browse “ti-96W i 6“ Listed o'r OPT-CE ' . _- _ _ pption‘fipremium pption premium 1 Options on. _ ype of gain] . ’ Increases. : Increases 1%ka gal; Individual loss depends on ST CG/L (reduces) price (reduces) \(alue : y m M ' hotding period I of stock of stock sale Shaw fl! purchase (sale) (purchase) Mykch 1 Type of gain/ OTC FOPtmns loss depends on I _ on 'Indices - (@ hoiding period _ _ _ _ _ r r r_ ('mnifimw U Mypfiefifl “J I (SrmUZow .mmJ-Noter Rules app'ye dip fifiim Broad Based Index Futures and Options- .C’V’L waefirhe‘ ' ‘ - '- - ' ' '0509251.Cor~9 M "We a We MW We is. . Futures and index Options mmm DECO/KW) ‘ 1256 Contracts extra _ _ _ \_ “"516 mMM} r -- r -- _ . t 5.03% $TC » bmeeLéjfi'fv‘BCMfi at) L! 2 _ -- ~.\ I - Examples of “1256” Contracts iflc’uc’e’ - ' futures, broad-based index options, and options on inde W W - 5&P 500 futures . futures ' - and options ' _ _ _ ' _ _, - a They are marked—to~market at year—end for tax purposes _ GMEM/(ke’futu-res _ - and any gain or loss is treated at 60% long-term and 40% Examples Oflndex ' r ' _ short—term, irrespective of the holding period futures whichare - . l ' ' ' not “1256” ' a Over-the-COunter (OTC) index options are treated the same - Commas" 1 l f ' as single-stock options for tax purposes -—— DAX fury/res ' - - LIFFEFT-SE futurés ' — Osaka Nikkei > Ability to sell short and > Unable to qualify for 100% - futures _ _ I obtain partial long—term long-term capital gain I n ' capital gain treatment. treatment. \ “A 5; 7%_3)°C!U > Holding period irreievant for , _ > ‘Marked—to-market at year- ,‘fi g, . ' iong-term/short—term capital | end for tax purposes. I J . ‘ ggain treatment. ' _ , 1 . r g . | ' x 7 r2. . 7‘“; e ' -- ' * ' 7 £7 :2:- gTSGa’L +6“! {' BEN/e View ‘95 . _ ' A r 63,Qowufla'%bw6/J ' ' .t ' ' -. . ._ - '«flz'pgepey {weran Ewe) 11 «seem-core at: 23‘: "buy Ettore. iiw " ' ‘ » - \——/ I _ ' f...‘ was My” 33M: 3 W 352525;; filim4;§i::¢’ Mme» Principal-Protected ELN generally are treated as “Contingent Payment Debt , Instruments” (“CPDIs”) for US. federal income tax purposes. Even if a CPDI \ does not pay a coupon, an inveStor generally is treated for U.S. federal income ' ix - tax purposes as if it were entitled to coupon payments equal to the CPDI's r / _ W9 _ A _ ' “comparable yield”= This comparable yield is based on” the rate at which the i - / @Q’VG («outfit Db issuer could have issued a plain vanilla bond having certain-similar - ( g — Q » characteristics, including maturity and subordination, as-the Note. As a result, (“13? W” \\ U7 “Wad U??? C" W a holder of a CPDI must pay-tax on “phantom income” prior to the maturity of am} ‘9 /4B\ , ' A thenote. All income and gain from holding or disposing of a CPDI generally is _ (liq ' . (g taXed as ordinary income _ - I «ELK-egg) w G I m The cost basis of the note is increased yearly by the amount of “phantom - ‘ Ii - income. treated as taxable income forthat year ' fig . I. (“:3‘ -. I " -- r I -‘ , y La/ bl»er ch 0%“ m If a CPDI matures at a price greater than the adjusted basis, the investor l - ' pays tax on the excess of maturity price over the adjusted basis i for Equity Linked Notes , "If. a,CPDI matures at a price iess than the adjusted basis, the investor has an ordinary ioss equal to the excess of. maturity price over the ’ I adjusted basis - N2547- Often difficult to classify for U.S. federal income tax purposes, although the . : WW H _ I most basic varieties often are characterized as prepaid,'cas'h-settied forward {up a 5 ' , 'i [,1' ' 2' _ _ A- _ contracts. Ali income, gain or loss from holding or disposing of a Non Principal- {felt a; W " ' __ - ' FM , Protected ELN characterizedas a for'Ward contract generally is taxed as capital W NW” 4 b0 W gain or ioss ‘ - ' were“ , _ I _ . (K _ 12 jive tin“ “We mi Na? in fw on Ctch Mi” C“; WWW mew“ “dd I'IJ . ososzsz—mr-s n59,§,.§;P¢cific Strategies 'megamem Hedging a Single Stock Constructive sale Straddle a Estate impliCatiOth '- '- Portfolio Hedging ' ' Straddle rule Tax-Efficient Short Selling ms- w [email protected] ' Stock vsf.. derivativesrtax treatment ' ' . '_ .' Tax Loss Harvesting - a Wash salejrule mam-Cabs H‘P‘ ‘ . /“IL ._;‘ . - so, ' - _.... 13 Specific Considerations in Hedging Single all _igaa«clw'idci4~ t5 usolaiealfi / I 'All of the hedgingtransaCtions below are ineffectivecbecause they result in the recognition of a capital "gain wi- ' u mmwflmmmmmwfimugm Sian agfiuwgr W‘ <it,7__.__.a._..c...._.1. Short sales of the same or substantially identical property if. was t - : Hi. Gm ' _ ' 2. An offsetting'equitys'wap with respect to the same or “,7, W9 Sggfuahfue—FSLM _ subStantially identical property _' ' . ' . Cilia}? PWL/Qge \. , . 3. A futures or. forward contract to'deliver the same or 2 Q8! D’ . “If ) ‘ - Substantially identical property - .betrle: éjlff‘V' ‘4. In the case of an appreciated financial position that is itself _ i 5.. p ' . a short sale, _entering into an offsetting equity swap, or a Q‘- 4” St -- futures or forward contract,with respect to thesame of ' [W\ wall) 1?? _- ; similar property; and Cw: Q any transaction that has substantially the same effect as _ ' ' : - -’ a i any of the foregoing transactions As a result,_ an effective hedge wires .1.“ ,n... 1.. flak thatis notoffset by the "derivative. This has le \ I if in QSI. Collars ’as the strategy most frequently used ‘ m _ {PM} Skha! n CCLN’l’ {hag - U and state Implications. - - .u-i EKWE-h‘r'bf. at. I. I If one position “substantially diminishes the risk of lossi’ of another, the . two positions are part of 'a straddle. ' ' EXampies of-sfladdles: _. I . i Hedging a stock with aswap, long put or short non—qualified (e.g._, i“ 3‘- _. ' deep—inethemoney) call _ . _ ‘ gm - . _ E Selling index futures or calls, or purchasing index puts, against a - ' & ‘ “ portfolio_that_ holds over 70% of the market capitalization of the _ WV?" ‘ index _ ‘ ' ' ' 'If hedgedppsition is deemed a straddle, the holder becomes unable to deduCt IOSses to the extent of‘unrecogniz’ed gain in the position and loses tax preference on all otherwise qualified dividends ' Equities and equity derivative positions generally are mar‘ked- to—market ' eitherupondeath or‘6 months after the date of death to vaiue the estate ' for" tax purposes; The inheritors of the estates’ assets receive such securities with a “stepped-up” basis equal to that marked-to—marketfair ' market value ‘ - ' “[5 _ 0669251-Cor-9 Hedge the overall portfolioWith‘ | index futures or options. 77W 9 l - Considerations: ConSiderations: - ' n Constructive Sales m Straddle Rule in straddle Rule: To what ‘ extent do the portfolio and ' I the index-overlap? - m Different tax treatment of listed versus OTC options 0669251-C0r-9 16 i '1 _, ,fi n = .. n' A 2:) ijC‘} [email protected] W 6i W w hort i Eng - ‘ M v. mi .1 9m». WW‘w-sw- Mae'siwmd’s'dww—"n7: '-:.:u InvestOr establishes a Cash- settled, synthetic short (buy ' put/sell call) with a maturity I Buy an infith'eemoney, European ' styie,‘ cash—Settled put with a. I maturity greater than 1 year. At maturity, if the put remains ' greater than 1 year. At limbo; :1 4T“ ' in the money, investor maturity, if the stock ‘ recognizes long term capital ' . depreciates, the investor gain in an amount eqUai to the recognizes long term capitai excess of strike price over stock 1 gain in an amount equal to the price, less premium paid ' excess of strike price over stock ' ‘ i ‘ a - ' price,-Iess put premium paid; premium received in respect of the call generally would be taxed as short-term capital gain at-maturity ’l I’ oeoszslm-s ‘ . (""3 /+-—\ A.“ ng 4—- Example l...l..- - « Wamxezmxwasch, A portfono‘ manager bEIieves a Stock She follows is. _ going: to decline over the next year. - ASSUme she'can. establish a bearish polsition‘on the stock which is currently. at $100 in one of three ways: 1-. Short stock at $100, rebate rate-is 4% per Year 0le nag (2. Buy 366 da uts struck at 117 for $18 {rs-raw 61w- 1 7 ,Ti I 7 i * 3. Bu ""3 ' ts struck at$100 for $9, fig” 366 . calls strch at$100 for $13 CSWC 8km) ' ' Swat-imam C6154 _ I ‘ Theinvestor’s marginal tax rates are 40%ufor . ' ordinaryinc-ome and short-term capital gains, and _ 20% for long-term capital gains 18 0609251-Cor-9 "Tamefficient Short Seliing m"- Example : _ I $563 L . .. , ' Q5? °‘ 18 A hédge Lo .l ' - ' Imitw" V {LG 6“ CM? W W W ' +61 sh SW 533 Gain or Loss on Stock + Rebate :7. * Ignores lcost of-financmg p‘ut . Gain orsLossJon Put 3. Gain 0r Loss on P'u't -i'~ Gain or LoSs on Call . 19 060925 1-Cor-9 . . - [A 4‘, if _ I, \ ' \. «.1 WWW £34:ka‘921 .. Ha Nesting Capital Losses 0609251-C0r-9 0509251-C0r-9 Ules mmw “m di‘i’xfiifi-‘Jfi‘ffibflfiEM‘Z’FFE?WAG)!" Jet-.1? r.-. '- I . Prevents taxpayers frOm' selling securities‘at a loss and re— ‘ acquiring “substantially identical” securities within a 30—day period before-_or_-_after the loss sale Where the Wash sale rules apply, the client’sbasis in substantially identical stock is increased by the amount of any: " ' ' disallowed loss ' The underlying instruments are substantially identical if the r ' marketplace views them as such (i.e._, the movement of one security is highly correlated with the movement of the other. security) Call options: Dueto a statutory ruley'p'urchasing any-cail after realizing a loss by selling along position‘violatesthe wash—sale l’Ulé - . _ _ \_ Put options: Generally, selling a put after realizing a loss by selling a long position should not violate the wash-sale rule-if it is not “deep in themoney,” although current law is unclear as . to what may Constitute “deep in the money” for this purpose 2’! ...
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nba694class09 - EquityDerivatives andReEate...

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