Equity Derivatives

Equity Derivatives
The Big Picture
Khader Shaik
www.ksvali.com

Equity Derivatives

  • Derivatives
    • Derivatives are based on Cash market instruments (cash products) such as stocks, stock indexes, bonds, currencies and commodities etc.
  • Equity Derivatives
    • Equity Derivatives are derivatives that are based on Stock, Stock index or basket of stocks.

Role of Equity Derivatives

  • Risk Management of Portfolio – modify the risk characteristics of a portfolio
  • Return Management of portfolio – enhance the return of a portfolio
  • Cost Management of portfolio – reduce the costs associated with portfolio management
  • Regulatory Management – achieve efficiency in the presence of legal, tax, or regulatory obstacles

Equity Derivative Markets

  • Listed Market
    • Traded on Exchanges
    • Provide Exchange guarantee
    • Product Types
      • Options, Futures, Warrants
  • OTC (Over-the-counter) Market
    • Traded directly between counterparties
    • There is a credit/counterparty risk involved
    • Product Types
      • OTC Options, Forwards, Swaps

Product Categories

  • Equity Derivative Product Categories
    • Futures
    • Forwards
    • Options
    • Swaps

(To learn more on basics of derivatives visit ‘Derivatives – Basics’)

Listed Market

  • Options
    • Stock Options
    • Options on Equity Indexes
    • Options on Futures Contracts
  • Futures
    • Single Stock Futures
    • Equity Index Futures
  • FLEX (FLexible EXchange Options)
  • LEAPS (Long-term Equity AnticiPation Securities)

Pros & Cons of Listed Products

  • Pros
    • Exchange guaranteed, hence no counterparty risk (credit risk)
    • Standardized in nature – expiration date, underlying, settlement style etc
    • Lower transaction costs
  • Cons
    • May not suite certain needs of Portfolio – duration , quantity etc
    • May cost more to hedge the portfolio in certain situations

Options – brief introduction

  • Option
    • Right to buy (sell) the underlying at a predetermined price on or before a specific date
  • Option Buyer – gets the right, but not obligated
  • Option Writer (Seller) – issues the right, and obligated to fulfill, if the buyer exercises his right
  • Strike Price is the price of the underlying that both agreed upon
  • Expiration Date – contract expires on or before the expiration date

Features of Options

  • Option Type
    • Call – right to buy the underlying
    • Put – right to sell the underlying
  • Exercise Style
    • European – can be exercised only on expiration date
    • American – any time on or before expiration date
  • Roles
    • Option Holder/Buyer – pays premium (option price)
    • Option Writer/Seller – receives premium

How listed products reduce risk?

  • Customers have to deposit margin (writer in case of option)
  • Daily marked-to-market and margins are adjusted
  • Member firms provide guarantee
  • Involvement of Clearing house in the process
  • Clearing house is the counterparty for all customers
  • Obligated to fulfill the contract
  • There is only risk of Exchange defaulting (very low)

Features of Listed Option

  • Underlying Security – Stock or ADR
  • Contract Size – 100 Shares of common stock or ADRs
  • Strike Price
  • 2 ½ points for Strike price b/w $5 and $25
  • 5 point for strike price b/w $25 and $200
  • 10 points for strike price over $200
  • Delivery – 100 Shares of stock or ADRs
  • Exercise Style – American
  • Expiration Cycle – Two near-term months + two months from Jan, Feb, or March quarterly cycles
  • Open positions are limited (market cannot write infinite number of options on one company’s stock)

Stock Index Option

  • Options on the popular stock indices
    • S&P 500
    • S&P MidCap
    • Russel 200 Index
    • Nikkei 225
    • NASDAQ 100
    • NYSE Composite Index and more
  • Helps to hedge the whole sector or portfolio
  • Reduces the cost of buying option (as oppose to buying individual options)

Features of Listed Index Option

  • Underlying – Stock Index
  • Contract Size – Multiplier * Index Price
  • Strike Price – 5 Points. 10 point intervals in far-term month
  • Settlement – Cash (no stock delivery)
  • Exercise Style – American
  • Expiration Cycle – 4 near-term months

FLEX (Flexible Exchange Options)

  • Customizable Options with Exchange guarantee
  • OTC like product but with no Counterparty risk
  • Customizable dimensions (attributes)
    • Underlying Asset
    • Strike Price
    • Expiration Date
    • Settlement Style
  • FLEX Options
    • Equity FLEX Options
    • Index FLEX Options
  • Learn more about FLEX at –

Features of FLEX

  • Category – Underlying security
    • Equity based (individual stock)–> E-FLEX Option
    • Index based -> FLEX Option
  • Contract Size
    • Equity – 100 shares (common stock or ADRs)
    • Index – Multiplier * Index Value
  • Strike Price
    • Equity
      • Calls – same as standard calls
      • Puts – Dollar value or percentage
    • Index
      • Index Value, Percentage or Deviation from Index Value
  • Settlement & Delivery
    • Equity – Shares
    • Index – Cash
  • Exercise Style
    • Equity – American or European
    • Index – American or European
  • Expiration Cycle
    • Equity – 1 day to 3 years
    • Index – Up to 5 years

LEAPS

  • LEAP – Long-term Equity Anticipation Securities
  • Offer options with longer maturities
  • Maturities range up to 39 months
  • Available on Stock and some Stock Indexes
  • Learn more about LEAP –

Features of LEAP

  • Underlying – Stock or Index
  • Contract Size –
    • Equity – 100 Shares or ADRs
    • Index – Full or partial value of stock index
  • Strike Price
    • Equity – same as equity option
    • Index – based on the contract size
  • Settlement
    • Equity – Shares
    • Index – Cash
  • Exercise Style – American or European
  • Expiration Cycle
    • January expiration only – up to 39 months from the date of initial listing

Option Price (Value of Option)

  • Price of Option = Intrinsic value + Time Value
  • Intrinsic Value: Economic value if it is exercised immediately. If there is no positive value then intrinsic is zero.
  • Intrinsic value of Call option = Current Stock Price – Strike Price
  • Eg: 105 – 100 = 5
  • Option is in-the-money (ITM) – if the intrinsic value is positive
  • Options is out-of-the-money (OTM) – if there is no intrinsic value (negative)
  • Options is at-the-money (ATM) – if the intrinsic value is zero
  • Time Value – is the amount by which the option price exceeds its intrinsic value prior to expiration. This is the premium buyer is willing to pay

Factors influence Option price

  • Spot price of the underlying
  • Strike price
  • Time to expiration of the option
  • Expected price volatility of the underlying over the life of the option
  • Short-term risk-free rate over the life of the option
  • Anticipated cash dividends on the underlying over the life of the option

Option Pricing

  • Option pricing one of the important thing in asset management world
  • Usually portfolios hold numerous types of options in large numbers
  • Popular Option pricing models
    • Binomial Model
    • Black-Scholes Model

Option Price Sensitivities (Risk Factors) / Greeks

  • Delta
    • The degree to which an option price will move given a small change in the underlying stock price
    • Option price sensitivity to the price of the underlying:
    • Delta (Call Option) = Change in price of call option/ Change in price of underlying
  • Gamma
    • It measures how fast the delta changes for small changes in the underlying stock price.
    • It is delta of delta
  • Vega
    • The Vega (also known as Kappa) of an option measures the dollar price change in the price of the option for 1% change in the price volatility
    • Vega = Change in option price/1% change in price volatility
  • Theta
    • The change in option price given a one day decrease in time to expiration
    • It is a Time decay
  • Rho
    • The change in option price given a one percentage point change in risk-free interest rate

More on Delta

  • Eg: Delta is 0.4 means that a $1 change in the price of the underlying stock will change the price of the option by approximately $0.40
  • Delta varies from ZERO to ONE
  • Zero Delta Call Option – Deep out of the money
  • 1 Delta for call option – deep in the money
  • 0.5 delta for call option – at the money

FUTURES

  • Contract between two parties, a buyer and a seller, where the parties agree to transact with respect to the underlying at a predetermined price at a specified date. Both parties are obligated.
  • Long position – Party going to buy underlying goes LONG.
  • Short position – Party going to sell underlying goes SHORT.
  • Price agreed to transact is referred as – Futures Price.
  • Date on which transaction is going to take place – Delivery date or Settlement Date
  • Initial deposit by – Good faith deposit. Held by broker/exchange in the form of short-term credit instrument.
  • Futures are marked-to-market on daily basis and settled daily. Daily profit/losses or credited/debited to margin account.
  • Daily cash flow from the futures positions is referred as – Variation Margin
  • Nearby Futures Contract – the contract with the closest settlement date.
  • Most distant futures contract – the contract with longest settlement date.
  • Futures with multiple settlement dates are traded same time

Features of Futures

  • Components of Futures are:
    • Futures price
    • Amount/qty of underlying
    • Settlement/delivery date
    • Settlement type (cash/delivery)

Options Vs Futures

  • Option Buyer (long position holder) has right but not obligated to exercise (execute transaction).
  • Option Writer (Short position holder) is obligated to execute transaction if buyer desires.
  • In case of futures, both parties are obligated.
  • In case of option, only buyer pays premium to writer. Where as in Futures there is no premium.
  • Options Vs Futures (cont.)
  • The premium paid is the cost of buying option or cost of eliminating/modifying the risk.
  • In case of Futures all the cash flows are either gain or loss.
  • Futures payout is symmetrical (as underlying price changes, gain/loss changes dollar-for-dollar) where as options payout is skewed.
  • Profit/Loss from Futures is unlimited. Option buyer has limited loss unlimited potential. Option writer has limited profit (premium) and unlimited loss (down side exposure). Hence Options can be used to hedge asymmetric risk whereas futures can be used to hedge symmetric risk.

Listed Equity Futures

  • Listed Futures Categories
    • Stock Futures (Single-stock Futures)
    • Futures with single stock as underlying
    • Stock Index Futures
    • Futures with one of the Index as underlying
  • Futures Price
    • Future Price is the price of the underlying at future date
    • Futures Price = Spot Price + cost of financing – dividend yield

Popular Index Futures

  • S&P 500
  • S&P MidCap
  • Russel 200 Index
  • Nikkei 225
  • NASDAQ 100
  • NYSE Composite Index and more.

OTC Equity Derivatives

  • OTC derivatives help investor with
  • Cost minimization
  • Diversification
  • Hedging
  • Asset allocation
  • Risk management
  • There are three categories
    • OTC Options (stock, basket of stocks, stock index)
    • Warrants
    • Equity Linked Debt Investments
    • Equity Swaps

Pros and Cons of OTC Market

  • Pros
    • Provide longer-term products to match investment horizon
    • Provide flexible structure to meet exact risk/reward requirements
    • Provide many more custom features unique to individual portfolio needs, hence the lower cost of hedging portfolio
  • Cons
    • There is no exchange guarantee, introduces credit or counterparty risk

OTC Products

  • Usually OTC derivatives could be
  • Stand-alone single products, or
  • Structured Products – Package of multiple OTC products (to suite specific need)

OTC – Risk Mitigation

  • The key risk of OTC Derivatives is the Counterparty Risk (Credit Risk).
  • Both parties are exposed to this risk.
  • OTC market has adapted many measures in contracts to minimize this risk.
    • Netting agreements
    • Position limits
    • Use of collateral
    • Re-couponing
    • Credit trigger provision
    • Derivatives Product Companies

Measures

  • Netting agreements
    • will allow to new payment of all agreements between two parties is owed in case of default
  • Position limits
    • are imposed based on specific counterparties credit worthiness and cumulative positions Use of collateral
    • some counterparties are forced to furnish collateral in various forms (short-term liquid credit instruments)
  • Re-couponing
    • involves periodically changing the coupon such that mark-to-market value of the position is zero.
  • Credit trigger provision
    • in case any specific credit event of counterparty, contract has to be cash settled by that counterparty
  • Establishment of Derivatives Product Companies (DPCs)
    • dealers have established separate biz entities to server OTC Market and to acquire high credit ratings

OTC Options

  • Simple Options
    • Simple options are similar to Listed Options but modified features like extended maturity, size, exercise type, delivery mechanism etc.
  • Exotic Options
    • Exotic OTC Options usually with complex rules and structures.

Warrants

  • Warrant is right to buy underlying (stock) at a certain price until a predetermined date
  • Stock Warrants have the long-term time limit unlike options. Usually up to 5 years.
  • When Warrants are exercised company issues new common shares to cover the transaction.
  • Unlike Option – option writer covers them buy buying existing shares
  • Some Stock Warrants are also traded on exchanges

Equity Swaps

  • It is an agreement between two parties which provides periodic exchange of cash flows over a specified time period, in which at least one of the payments is linked to the performance of single stock, basket of stocks or equity index.
  • Equity swaps are very flexible and design with various features to suit the needs of the customers.

Equity Linked Debt

  • Equity Linked Debt is basically securities of non-public companies. It is also known as Private Stock or Private Equity. These don’t instruments don’t trade publicly, these are private deals arranged by Venture Capital firms, Private Equity firms or other brokerage firms.

References

  • Options, Futures, and Other Derivatives by John Hull
  • Financial Derivatives by Robert W Kolb, James A Overdahl
  • The Handbook of Financial Instruments by Frank J. Fabozzi CFA
  • Equity Derivatives: Theory and Applications by Marcus Overhaus, Andrew Ferraris, Thomas Knudsen and Ross Milward
  • Exotic Options and Hybrids: A Guide to Structuring, Pricing and Trading (The Wiley Finance Series) by Mohamed Bouzoubaa and Adel Osseiran
  • Chicago Mercantile Exchange – Major US Market – http://www.cmegroup.com/trading/equity-index/index.html
  • NYSE Group – AMEX – http://www.nyse.com/futuresoptions/nyseamex/1218155409117.html
  • Euronext – European Markets – http://www.euronext.com/landing/liffeLanding-12601-EN.html
  • You can learn more about derivative and other topics on my website – http://www.ksvali.com

Thank you
Khader Shaik
www.ksvali.com

Note: This is the transcript of my presentation – “Equity Derivatives – The Big Picture”