nba694class11-12 - Equity Derivatives ‘ Classes 11 and 12...

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Unformatted text preview: Equity Derivatives ‘ Classes 11 and 12: ' Exotic Equity Derivatives ' ' Mark Zurack . November 14 and 21, 2006 ssObJectIves u' -_ ‘.__}. =:-::=~a-m - 7.» wmfimé a: 2“:-n~:~e:¢uww.~:—:-c~=»w;ear:rxv‘muugzx u 1n v a » ~ . . . : I Introduce Exotic Derivatives to the‘class For each product revieWed, diScuss the payoff of the derivative and c0mpare its benefits and risks to comparable‘ ‘plain vanilla” options - ‘ Show examples of Exotic Derivatives transactions including Structured Notes On November 21, Justin Egan from Citigroup will discuss trading Volatility Derivatives 06102300141112 \r‘x I Path-Dependent I Carrelation. I I Volatility I _ I I Derivatives . Derivatives | Derivatives _ " Other - I I I Payoff not only I n 'Payoff depends on I H. Payoff depends I ' I depends on the I =now two risky assets - directly on the I ' ‘ . . underlyers value at - move . . I [volatility of the I I I Definition:- expiration but how I - I underlyer. I .I.- ' I it gets there I . - I I l" Barrier-Options II Relative Performance In Volatility Swaps I I Binary or Digital. I .I . -' - : - - ' . ' I_- I 3-. Lookback Options I Options. _ ' ' . I Variance Swa ,IIESEIIStIIZaVOUt I. _. 'I - a contingent Options I _ . . I ‘ -- . " I - _ I E- Average Rate . _ _ _ VIX Futures i . option expires I . - I (Asian) Options i I ' Guaranteed Exchange._ -_! :n-the-money) 'i- 7 I ,7. . . I Rate or Quantos I I ' ! I Products In bIllcluetr'fgat-nons I . Options E I : I a Ratche. ptaons. I 1 Rainbow Options I I I I ' ' If ' ' I ax'Best-of and Worst-of I ' ' _' I u I : I Ooti'ons I I ~ I _ I 'I i I ”I Himaiayan Options I 061m amz _ ' ' I ' - " um;n—H.-W«”,—-A—s_ _‘_l.aa-fi_r~':\ ~'.-—- wspah’rt—u nan—«vat:— Isa-WE. W‘.‘ Aft.» . "‘f “omrt‘wv'e-v—v- _ Path-Dependent Derivatives --_ _ BW‘EPUS __ I ' ' Option payoff depends not only .on whether the option expires in-the- money, but also on whether the price. of the underlying stock ever crosses a predetermined ievei or barrier during the life of the option There are-rtwoumain types of ”barrier options: knack-in options and knock-out options ' a" .A knock-in“ Option will only pay off if the junderiying‘asset - - finishes in-the~moneyand the barrier iscrdssed at some time prior to; expiration ' - - “WI 1 A knock-autoptic'm will-only pay off if the underlying asset is in- ” *. - (5.;de . the—money at'expiration and never crosses the-barrier during the ”am '% life ”of the contract. As soon as the underiying asset crosses the xmdi ou‘f‘v barrier, the-option is “knocked out” and“_eXpires worthless Benefits . _ Risks. - ' i i . FE 'CQStS-iess-than i H Knock-in and knock—out features reduce '- , ' .conVentional optiOns the probability of exercise '- " The higher the-‘voiatility, the more likely youwill hit the barrier. Probability else-affected by the ,fOrwarci price of the .underlyerjwhich depends on" interest rates and dividends oemmmuaz I _ " .2 i-Barrier Options +— Example . . :Thel po'ritfoiio manager in Class 8 could hedge her portfolio for ' 'one. year by purchasing-a put struck :‘5%'out-of—the-money . ' (OTM) for 2.8% and fund that put by Writing a call_8.5% OTM‘ ' _.Altemativeiy,' the manager can. buyer 5% OTMIpu't that knocks out £108.5er 2:7750/0 “’ (140}? if. inoEQx r/g‘ meo‘fic {fat A? W _ Straight Knockout put is Put I 30 bps cheaper but. = exposes-investor-to extra risk if index , ' goes above 108.5 couar _! :then declines. l heiow 95 - - 10.3%” max “m...“- z '90.: "95 100 ,195 1'10 5115 ! W @W mwfllfifififlb ...._........... ......__._.-_......-—T— Iii—P .m— Lokback Options“ i‘T Mania m». 3'3“ka -s.LoOkback optionsallow the investor to “look back” over the life of the option, andto choose to set the strike price of the option at the most favorable-price that had octurreci. This is accomplished by, determining the exercise price at the expiration of the contract instead of atcontraCt origination, asin a c'onventionai option '. Ivyear ATM Cali option .4. 10% ‘lryear ATM'cail struck at'the 'lowest Stock price over the next threefmonths = 15%. Loekback outperforms if the stock declines more than.5% over the- _ next three months ' - ' , Rising-"veiatility increases extra cost of iookback feature, term structure'also important ' q. : NEWER “11" . 3 (:93 maaaawg + garage Rate “Asian-"captions. 3...... Wm. Mum WI 0143 . _ _ ii}- ‘tcaitw wow-W ' Payoff depends-on the average (arithmeticdr geometric) of the ‘0 “ 3 52’ (WW aunderiying price of the mstrument- over a specn‘ieo period oftim _, notw "‘9 {u Him-“~33: WS- 3/(1/9, - 1.1.. 37 31—:— we WU—t'fl‘flafi - .w——--—-—-——¢.—-mm~¢nu-.___-i—.-—.—m- jUSt—the spot price at expiration _ . 4 {’57‘3 .A structurefl'acreating a 5~year, principai protected Equity_.l._in.ked I Note on the 583950.!) and has 23.5% to 1;}:ng on- options. Based on I the prices betow; hefshecan provide .31 /o_ of the appreciation of-the . index the regular way, and3449go Of'tfie appreciation with averaging. I Sayear ATM. caII-_0ption-0n'the S&P 500 .=. 205% I 5. (”5-year ATM caII option on the average - ' Lva‘fue of the 8&9 500 in; years 3, 4 and S- = 16.3% 1- I 3:-: Lowers cost 0f the option . I 3‘ ”Forward priCe iower' I I II Works best if you see the underiye.r I Range of outcomes for I ‘I I flattening out-in vaiue during - I -_ an aVerage Iess a I , averaging period, I - I \3 -. ' Reduces exposure to a single event I impacting underlyer at expiration I 0610230v00r-llfl2 ..‘ flyo 7 film am it Wench may «he mei- lCiqu-etO-ptionsk-sm e lcs-M amt - - Avatar-upwa- --v ' Payoff depends on the reset performance _of:.the underlyer over a . series of rolling periods; Thestrike price of the'option is'reset at the end of each time interval and a separate payoff-- will occur at the end of each perrod in which the‘option is in—th'e-money.- The payoff in any period'is equal to the performance of the-underlying security during that period less-the strike price, A Cliquet option can therefore be considered as a series of consecutive options ' An investor buys a 2—year ATM Cliquet call option. . At the end” of the _ first year; the payoff is 25 ._( 125 ~— 100) with the strike price reset to 125‘. 'At the end'of the'second year, the payoff is the max of (underlyer - 125; O) ' ' . - Benefits , 7 a . Risks : w Periodic gains are iocked inaSsurmg {a Valued at a premium i ' thatthe payoff willalways be ‘I' to a'piain-vanilla | __greater'_than or equal to the payoff : option due to ability to I lock-in appreciation In ' Limits downSIde risk because strike _ thexunderlyer 93‘3” price is reset each period ' per ““3 l l i of a plain-vanilla'eptton | l _— mun—u-u—mm-u —_._.._........ 0610230~Gor-1i112 = ' RatChet ptlons (minim gory» WM?“ - but ~ita (septum? 'mam._;x..s £0 brutal 6M (PM: NG'T «one. Payoff depends On a series of ongoing performance iock-In ieveis. _ S'Ohce a ievei Is reached, the payout is guaranteed to be at ieast that _ _ ievei. A Ratchet option can be used when an investor wishes to gain exposure to an underiyer but Iock-irI short-term price movements without haying to exercise the option prematurely _ E —. ‘An investor buys an ATM Ratchet call option with ratchet leveis at 120 and 130. When‘ the price of the underiyer crosses the first ratchet ievei this gain Is iocked- an, resulting In a payoff at maturity of 20 (1207-100) at maturity 7 Benefits _ m Lock~In short-term price appreciatiOn without foregoing the future life of the option plain-vanilla Option due to the abili tolock—‘in ains " Ratchet-Ineffective if. price of underiyer-abov'e ratchet ievei at expiration g“...__......-. Downside protection against Unfavorabie short-term price fluctuations due to existence of ratchet leveI a Possibiewayto lock-in short— term gains in-a-iong-term ' ' structure . -._._.-I-m-n-—-.—.—-.-."u-.um..."- Datum-11:12 Plain Vanilla and Comparing Path- ‘ Dependent Structured Notes - An- investOr- Is conSid‘ering the S&P 500 Equity Linked Notes below. All provide 100% principai protection and have five year terms. . Description ! Percent of Upside- ‘PiaihVaniiia" . ' - ie 115% ' Knocxs—out when the index rises 50%, pays 59% Immediateiy at knockout . - =n Beginning index Set torthe‘ lowest Index levei over the next—year fl -‘118°/o- \ I an 194% " {WWW-3 m.1_44% “'5‘“ ’ the end of. years 3, 4. and 5 _ ' ' 3T -;_3 Upside reset once a year _ 73% I 4' 737/3},T I Gains iocked In- every time the _ E 80% ‘Cmmii ‘ index goes up 10% . _ I i i ii: Based over average of the index at i _....._-.-_.....——-——.—_..._ _._......_-.-.——;_.Iu-.-_-——_um.m . osIom-oor-Imz WW3; yolmlili’rj 6-{1 correlation Derivatives— I I 1:23:13”; and fiecowelet. Relative Performance Options W “”9"“ ‘— “-"—5’—‘«‘ ‘ ““ VP'?‘ rmmwmbwafimmsfi Q‘s: ~1 at least: 2. omelehl m _ _ _ “flea/{la}: 3 j Wh_ Th They pay the holder the difference between the total or price return ' ' " ' of two different assets. In equities, those assets can be individual stocks, baskets of stocks, 0r stOck indices. Outperformance options canalso be structured between equities and bonds Reiafim FerfDmaAu OPhEM LOFHOA. on, OIlfle/E‘ncé bem‘ze" 2‘ Offibns‘) An investor believes small cap stocks willoutperform large cap stocks over the next year. He sees the following options prices: 1—year ATM call option on the Russell 2000 ' _ = 8% ~year ATM call option on Russell 2000 — S&P 500 (Prince return) ' ' ' - - 010““ 0" Gillie/en: c Leta/m Mm: anal 5M 3500 = 40/0 Note that the relative performance optiOn is cheaper than the straight Russell 2000 option and can profit in a falling market fiber“ _ _. 4 _ l Does not require absblute l Correlation unpredictable, Assume. q”: L 0:114 '2’” MM performance of underlyer wide bid/ask spreads : ' F 3 l: O I 734“? 10° ., - . I_ Usually cheaper than a Vela-lilig of Rum ’Sao 7‘?“ ”W" lib-M“? I .- conventional option- I Interest rate close to zero ' I Volatility depends on volatility of each asset and correlation between assets - . 7 10 0610230430r-1 1/ 12 -_ Guaranteed Exchange Rate (GER) or “to? ' I ___________________________ W" ,_ rears-:yt‘ \ -.‘ ...... 2“ ‘ {-*::a.‘.‘. 3—H ._ . Aux-z! s— --. x». mgcwewgmd‘r'w ccu . ...- - . . .. . ‘ A predetermined exchange rate is used to convert the final settlement vaer. of the options into the investor’s home currency. Effectively, the investor receives local market a returns in his underlying currency - I Can strip Out currency l Currency risk can have a risk pOSitive expected value I Can be less expensive than conventional options I Depends on interest rate differential of two currencies . _ x . I" Depends on correlation between underlyer and currency LVWHIj'-u!fi foreign 'invvlm' return an whole and refuna 0.4 enact-«32 mic ‘ CE‘R guaranteifli reium 0“ fink V" 7%???“ We? T5” 961°,va M [Mme . 0-1-7 SZ <—- Ewell; dolly {7Q ded|~Ae—@ase& :mIR Chit—f1) 54? 3.410 IfD'ClQ‘, exPec't rel—um 4,579 cw: 11 35W!“ in 5Mciu.red [minds clerk's i mean?“ ngb'K : _ “jaw LlBDK ;, 525% Lila/,4? IE“ (123436 11) 43mg} (on-W “gawk 56001 +0 Layer) _ _ Cawenc? -' _ s’fl‘ “Fed? “<1de .sfo‘t'rafite 7L0 be 4.570 "'3 lowew 17104 at jean ‘ 0610230‘Cor-11!12 l,__-“""‘\ osmm-w—nnz Equity— —Linked Note with a Twist — An Example I IVEK’ Jale, ' 6Y‘ “Quail/2+0” OF'JHMS mwfififi: I A US. fund manager desires exposure to .the Japanese ' stock market,- but Worries about possible weakness of the _ Yen and needed prinCipal protection. USD denominated equity— —linked Note on the Nikkei 225 stock Index . . Indicative terms: I 3-year maturity I 0% coupon 90%” principal protection I . In: 100% participation,no upside cap I USD/JPY fx rate locked In on trade date ‘ Unlimited possible return on the note. USD payoff. No exposure to depreciation of JPY. The note is only 90% principal protected. An investor could lose up to 10% of their principal amount. 12 gawk wore-Mien” {it JEE 7‘ Puff/0513' (€55 {41°14 Mgr/liar fay/iv bowl/3 .nsumncc r” " “gency Opt'ons M I - .- -;5.5 .5 .5 .5. 5.555. 5.5. .5.5. 5. .555.- .5.-55.557.55.555.— 55 mmfiwwfir awash spams: 5:555 ix w Payoff depends on the performance of two different assets. For the option to have value, the primary asset underlying the option must expire in-the- -money, and some other asset or rate must also perform in a specified manner A pension plan manager is worried the impact of a “perfect storm", that is a decline in both interest rates and the equity market. To hedge, he wOuld buy a one—year put on the S&P 500 contingent on a 50 bps decline in the 10-year treasury rate. A 5% OTM put with that contingency would cost a fraction of a plain vanilla put with the-same 5 strike and eXpiration - I Less expensive than I May not pay off When you conventional option need it to - . ,_ l_ Depends on volatility of primary asset, volatility of second asset and correlation between primary and secondary asset 13 0610230—Cor—11/12 {*5 r/‘\\ /.... 1 Payoff depends on the performance of a basket of securities in which the fixed weights of the securities are allocated at maturity, based on the realized performance of each of the underlyers ARainbow option can be used in a situation where an investor would like to gain exposure to a basket of securities, but is uncertain about the ”relativeperformance of each of the underlyers " I Allocation of predetermined weights at maturity according .to realized performance I' By assigning weights at maturity, ' ' RainbOW Options ensure optimal allocation for each underlyer in the chosen portfolio i Choice Of underlyers and weightings are ' - very-flexible and therefore customized _ for the client ' l Counter moves in the basket may lead to foregone appreciation of individual performance 14 0610230-Cor-11/12 Indicative Terms 4-Year Cross Asset Rainbow Note (FI'SE Index, GSCI Commodity Index & UK Government Bond Index Quarterly ASIan) ‘ - , .,.-.,- Wm‘em-mwm 33¢ 3;-».an-‘=‘<s\s:v.-mv.a.~x=-«s.~,- ~, : U " -' '. (Indicative Terms and Conditions— for discussion purposes only) 0J1“!!! jam Qflpfc/f 35d.“ H I Maturity dive? (W H) Choc) se “The . _ I ' best: Pertomi'fj qfl'efi) - ' Currency - " - l Redemption l Participation II Basket Return l Index Return I . . - I Underlying Assets: {(4 2/ Should A — Equity' 10% average “1””? I — Commodities: m, aflfl 3 Might/3A3 -. _ 51““ — Fixed Income: Short Width-4:1 and long I CowelaHM 061020-0341le {JR 4years - GBP 100% + Participation x Max(Basket Return, 0%) 120% ' (50% x Best Return) + (30% x 2nd Best Return) + (20% x 3rd Best Return) g C E OM mod“) r; 010 rainbow Quarterly ASian RGtUFn and fig?” OF'fiM (Amara opfion Moi-+£3— 444?, value 01L rum‘Laom/U" diwrjemce FTSE 100 Index — Bloomberg code: UKX <index> (Goldman Sachs Commodity Excess Return Index —_ Bloomberg code: GSCIER <index> The Bloomberg/EFFAS UK Government Bond Index “- Bloomberg code: UKGATR <index> 15 --of a d W (”std Opt'ons ‘_ ‘3 Wart-H T—Zfi’sfifi‘fii’iflxfiwfififir .'.‘-'5-" Bet _ Payoff equals 100%.of the return of the Best or Worst performing security in the basket ‘ ._ _, , . _ . A Best—of call option can be used by an investor with a sector specific view 685% 0“ Wla‘m‘fi ‘W’L 10"” who is looking to maximize the return based on the best performance of a Welahon (because o'l’henui w, specific underlyer in the sector. A Worst-of put option can be used by an mu Jug/g 19”? Wt! 0+ mm Aft-hm) investor as an indirect hedge on a single stock position where the investor is ' contractually restricted from entering into a direct hedge for a specific period An investor buys a 1-year ATM worst-of put option on Motorola, Ericsson and Nokia 'which are closely correlated to the investor’s single stock position. The payoff is equal to 100% of the depreciation of the worst-performing underlyer Problem —. Vex/U Weave, ophén relative to the strike price, I.e. 100% _x (40 — 100) = 60 Could; but? will Opt-Ibo on worst <4 2 ('Fajaf'F depends an Lot/k ) I "Gain/limit exp-Osure to the best or Worst l Best—0f call/Worst—of put performing securities in a basket through a valued at a premium to a '_ .single contract Rainbow option I Worst-of .call/Best—Of put less expensive than a plain-vanilla option ' 16 0610230-C0r-111'12 remaining life of the option Can. Chooée ({96" FEW-Dc} ) Jhck +0 IVVIEGVWVE Hlmalayan Optlons F:rlaomance of” barley? €351}? newsman $fi‘1"y-1Lt'\‘."‘.“£\“.‘”~k“‘ " ‘.'_"'. . :r» :- n * * * Payoff depends on the best or worst performing security in a basket during a specn‘" ed period. This security is then removed from the basket for the ' A Himalayan option can be used by an investor who is long-term bullish but is uncertain about the relative performance of different indices, sectors or single stocks'OVera specified time horizon An investor buys a 3-year ATM Himalayan call option on a basket comprising the DJ Eurostoxx Telecoms, Financials and Utilities sectors. Each year, the return of the best performing security relative to the strike price is recorded. This security is then removed from the basket for subsequent periods. The final payoff is equal to the average of all the returns computed as above, subject to a global floor of zero, i. e.- 100% x (1.—-10 100) + 100% (120— 100) + 100% X (110 — 100) '= 40 - I Lower premium than other correlation products I Gain exposure to the best performing security in a basket in each period through a single contract ' I May be used as an automated and dynamic I Best or worst performing security is removed from the basket at the end of each period, thereby potentially foregoing future appreciation in that security 0610230-C0r-11I'12 ,—“"‘"‘x portfolio management tool 0610230-Cor-11j12 _ Best. of Best-(Example) ‘ at: . Automobiles DaimlerChrysler - DCXGn.DE Equity EUR - \_ Volkswagen AG __ _ VOWg.DE ; EqUIty EUR Unilever ' Unc.AS Equity EUR F nd Be e a - - EUR Deutsche Bank I DBKGn.DE Equity EUR BNP Paribas ' BNPP.PA Equity EUR Energy Royal Uutch RD.AS Equity ‘ EUR _ Total Fina Elf . TOTF.PA EqUIty EUR Chemicals _" Bayer AG ‘ - BAYG.DE Equity EUR BASF AG . BASFDE Equity EUR E.0_N EONG.DE Equity EUR IRWE I RWEG.DE - Equity EUR Allianz AG _ ALVG.DE Equity EUR Miinchener R'Lickversicherungs AG 7 MUVGn.DE n Equity EUR- Healthcare 1 ..Aventis . - ' - AVEP.PA . Equity EUR "‘Pha‘rmaceuticals Sanofi-Synthelab SASY.PA ' EUR I Telecommunication DTTelekom DTEGn-DE Telefonica TEEMC . notes Lembedai ea warm) Payment Short volatility , loqj Cowila'fién A , mammwimgmqm if?“ EUR rnrnrn 23.0 ESE HQ Music emit: Solcl m fithlur'tcL 18 mommy-11112 .1 Best of Best (Example) 11.11-11.12 rrrrrrrr -.1- :11-.1.111—=1.1=.1.1.1 .111 .-11.:.1.-111.1.1.1.1.1..1.1.1.1_ 11.111.11.111 1111-1 111.11.111.11. 1.1.. .1111. .11 11%511'11m131m1a31w:11 13113. .13. =1. 1:151 1‘ .c. 9 Start Date .. - , _ : Semi-annual for the firSt 3 years and annually after that I9 dates oal) On any Strike Fixing Date and/or PriCe Fixing Date which is not a Bad Day Reference Price shall mean the official closing price : Modified postponement ' ' At Maturity Date the Counterparty B shall pay the Counterparty A a EUR amount ' defined as: The notional amount multiplied by the maximum between ‘i 1.8 80% of the average of the 9 returns ' 1 Ii. Zero Where: Return 1: Return of the Best asset in the basket of 18 assets at date t After t1, this best asset and the asset belonging to the same sector are taken out of the Basket Returniz: Return of the Best asset-in the basket of 16 assets at date t2 After t2, this best asset and the asset belonging to the same sector are taken out of the Basket Return 3: Return of the Best asset in the basket of 14 assets at date t3 After t3, this best asset and the asset belonging to the same sector are taken out of the Basket Return of the Best asset in the basket of the 2 remaining assets at date t9 European. Market: Mat/La In exam—C 'eiull'j 19 rm (Jemima-W Pmdwcf's - r1113 Elmohz/erfi Pmolud’S‘ [SK 192+th rtvtmtfi in ER ‘...
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