Introduction to Equity Derivatives. February The Derivatives Consulting Group Ltd

Transcription

1 Introduction to Equity Derivatives

2 Course Agenda Part 1: Introduction to Equities The Basics Types of Stock Dividends Corporate Actions Underlyings Market Institutions Part 2: Introduction to Derivatives Definition Origins Asset Classes, Types & Products Trading Methods Settlement Methods Part 3: Forwards & Futures Contract Features Valuation Spot vs. Forward The Distribution Graph

3 Course Agenda Part 4: Options Options vs. Forwards Contract Features Basic Option Valuation The Greeks Option Strategies Part 5: Equity Swaps & Dividend Swaps The Basics Price Return vs Total Return Bullet Swaps vs Resets Trading Strategies Dividend Swaps Part 6: Variance, Exotics & Correlation Variance Definition Variance Derivative Products Exotic Terms & Features Correlation Definition Correlation Derivative Products

4 Introduction to Equity Derivatives Part 1: Introduction to Equities 4

5 Stocks and shares: The basics Why do shares get issued? How are share prices determined? What drives share prices up and down? Why do people invest in shares? 5

6 Stocks and shares: Shareholder rights Part ownership Voting rights: A vs B shares Concept of limited liability Dividends Common Stock vs Preferred Stock 6

7 Company Payment Obligations Company Employees Premises Taxes & Svcs Loans Bonds Dividends on Preferred Shares Dividends on Ordinary Shares 7

8 Dividends: the basics Why are they issued? How are they determined? Company obligations re dividends Dividend dates: declaration, ex-dividend, record & payment Cash vs Stock dividendsid d Regular vs Extraordinary dividends 8

9 Corporate actions Stock Splits & Consolidations Mergers & Acquisitions Rights Issues Bonus Issues (aka Scrip or Capitalisation Issues) Spin-offs Nationalisation Delistings 9

10 Mergers & Acquisitions: Pros & Cons Pros - Increase in sales/revenues ie Procter & Gamble takeover of Gillette - Venture into new businesses and markets - Profitability of target company - Increase market share - Decrease competition (from the perspective of the acquiring company) - Reduction of overcapacity in the industry - Synergy of resources - Enlarge brand portfolio ie L'Oréal's takeover of Bodyshop Cons - Reduced competition and choice for consumers in oligopoly markets - Likelihood of price increases and job cuts - Cultural integration/conflict with new management - Hidden liabilities of target entity 10

11 Mergers & Acquisitions: Top 5 in 2000s Rank Year Company A Company B Value (USD) AOL Time Warner 164,747,000, RBS, Fortis, Santander ABN AMRO 95,500,000, Glaxo Wellcome SmithKline Beecham 75,961,000, Royal Dutch Shell 74,559,000, AT&T Inc BellSouth Corp 72,671,000,000 11

12 Equity Underlyings Shares Indices Baskets ADRs 12

13 Underlyings: Basket Example Share Share Price Shares of each Share start value A B C D Total:

14 Stock Exchanges Tokyo Stock Exchange London Stock Exchange New York Stock Exchange 14

15 Stock Exchanges: the basics Products Listings Primary Market vs Secondary Market Open Outcry vs Electronic Clearance Systems 15

16 Stock Exchanges: its roles The main roles of stock exchanges are: - Raising capital for businesses - Mobilizing savings for investment - Facilitating company growth - Redistribution of wealth - Corporate governance - Creating investment opportunities for small investors - Government capital-raising for development projects - Barometer of the economy 16

17 Stock Exchanges: Black Monday DJIA Drops 22.6% (508 points) million shares traded (a new record) Previous record set on the previous Friday (338 million shares) Only half a day of trading on Black Monday overtook this number Ticker board was so heavily inundated it ran 2 hours behind the market 17

18 Stock Exchanges: Black Monday (cont d) Possible Factors - Share Overvaluation? - Programme Trading? - Trade & Budget Deficits? Resulting Changes - Restriction of Programme Trading - Introduction of circuit breakers ie the SEC now requires that all exchanges cease trading in the event that one of these circuit breakers is triggered 18

19 Introduction to Equity Derivatives Part 2: Introduction to Derivatives 19

20 What is a Derivative? Definition History Asset Classes Leverage Future Settlement 20

21 Creation of a Derivative CHOICE ASSET CLASSES INTEREST RATES EQUITIES F/X DERIVATIVE TYPE CREDIT COMMODITIES OTHER SINGLE NAME DERIVATIVE PRODUCTS BASKET INDEX FORWARD SWAP OPTION EXOTIC OPTION CORRELATION 21

22 Derivatives Overview Long vs Short OTC vs ETD Cash vs Physical 22

23 ETD vs OTC Overview Contract Specifications Contract Payments Contract Flexibility ETD Standardised by derivatives exchange Margin paid into exchange clearing house account Freely tradable on exchange OTC Determined on trade-bytrade basis between parties Paid directly between parties Unbreakable unless agreed otherwise by parties Contract Agreement of trade verified Legal confirmation signed Obligation by exchange between parties 23

24 Introduction to Equity Derivatives Part 3: Forwards & Futures 24 24

25 Forwards: Contract Specifications Number of Forwards Forward Price Valuation/Settlement Date Settlement Terms 25

26 Forwards vs Futures Overview Futures Forwards Contract Standardised by derivatives Determined on trade-by- Specifications exchange trade basis between parties Contract Payments Contract Flexibility Margin paid throughout life of trade into exchange clearing house account Freely tradable on exchange Paid directly between parties at maturity Unbreakable unless agreed otherwise by parties Contract Buyer pays seller current Buyer pays seller agreed Obligation market price forward price Contract Agreement Agreement of trade verified by exchange Legal confirmation signed between parties 26

27 Forwards vs Futures: An example Today Share price of XYZ Ltd = $100 per share Both Bank A and Bank B believe the price will increase over the next year Bank A elects to buy a 1 year forward contract from another bank Bank B elects to buy a 1 year futures contract on the derivatives exchange 27

28 Forwards vs Futures: An example (cont d) In one year s time Share price of XYZ Ltd = $200 per share Bank A obliged to buy $100 = Bank A net + $100 Bank B obliged to buy $200 & receives $100 from margin account Bank B net + $100 Both banks net the same amount although the cash flows are slightly different 28

29 Forward Valuation Forward Price = Spot Price + (Carry Cost Benefit) Basis Spot vs Forward Arbitrage 29

30 Spot vs Forward 30

31 Forward Trading Example 1 Forward Price = $105 (ie too high) Today Borrow $100 from bank & buy shares now Sell $105 In one year s time Deliver shares & receive $105 Receive $2 dividends (total receivables $107) Repay the bank your original $100 plus 5% = $105 Therefore total = + $107 - $105 = + $2 31

32 Forward Trading Example 2 Forward Price = $101 (ie too low) Today Borrow the shares from the stock-borrow market & sell them for $100 Invest $100 in bank Buy $101 In one year s time Receive shares & pay $101 Give back these shares to lender & pay $2 dividends (total payments $103) Withdraw your original $100 from bank plus 5% = $105 Therefore total = - $103 + $105 = + $2 32

33 Forward Price Distribution Graph Forward Price distribution chart assumes that the forward price will not move outside the range Forward Price Distribution is centred around its mean 33

34 Forward Price Distribution Graph (cont d) Forward Trading Example Shape of Normal Distribution Normal Distribution is Bell shaped 34

35 Introduction to Equity Derivatives Part 4: Options 35 35

36 Options vs. Forwards Forward Price Forward Buyer obligated to buy at Forward Price Call Option Buyer has the right to buy at Strike Price 36

37 Options: Contract Specifications Option Style Option Type Number of Options Strike Price Expiration Date Settlement Terms 37

38 Options: Standard Option Formulae Call: N x Max (S K, 0) Put: N x Max (K S, 0) Where: N = Number of Options K = Strike Price of the Underlying S = Price of the Underlying when exercised 38

39 Options: Long Call P&L Graph 39

40 Options: Long Put P&L Graph 40

41 Options: Short Call P&L Graph 41

42 Options: Short Put P&L Graph 42

43 Option Valuation: the basics Option Value = Intrinsic Value + Time Value Intrinsic Value Time Value Volatility Length of Time to Expiry Other Factors 43

44 Option Valuation: The Greeks Delta Gamma Vega Theta Rho 44

45 Option Strategies: The Basics Synthetic Forwards Spreads Straddles Strangles Collars Butterfly 45

46 Option Strategies: Synthetic Forwards Number Of Option Trades = 2 Different Components: Seller Buyer Option Type Usually Net Premium = 0 46

47 Option Strategies: Synthetic Forwards 47

48 Option Strategies: Synthetic Forwards 48

49 Option Strategies: Spreads Vertical Spreads Horizontal Spreads Diagonal Spreads Ratio Spreads 49

50 Spreads: Vertical Spreads Number Of Option Trades = 2 Different Components: Seller Buyer Strike Price Premium (usually) 50

51 Spreads: Bull Call Spread Example: Buy 330 Strike Call Sell 350 Strike Call 51

52 Spreads: Bear Call Spread Example: Sell 310 Strike Call Buy 330 Strike Call 52

53 Spreads: Put Spreads Bear Put Spread Buy 330 Strike Put Sell 310 Strike Put Bull Put Spread Sell 350 Strike Put Buy 330 Strike Put 53

54 Spreads: Horizontal Spreads Number Of Option Trades = 2 Different Components: Seller Buyer Expiration Date Premium (usually) 54

55 Spreads: Diagonal Spreads Number Of Option Trades = 2 Different Components: Seller Buyer Strike Price Expiration Date Premium (usually) 55

56 Spreads: Ratio Spreads Vertical or Horizontal Spreads Other Different Components (ie Number of Options) 56

57 Option Strategies: Straddles Number Of Option Trades = 2 Different Components: Option Type Premium (usually) 57

58 Option Strategies: Straddles 58

59 Option Strategies: Straddles 59

60 Option Strategies: Strangles Number Of Option Trades = 2 Different Components: Option Type Strike Price Premium (usually) 60

61 Option Strategies: Strangles 61

62 Option Strategies: Strangles 62

63 Option Strategies: Collars Number Of Option Trades = 2 Different Components: Seller Buyer Option Type Strike Price Premium (usually) 63

64 Option Strategies: Collars 64

65 Option Strategies: Collars 65

66 Option Strategies: Butterfly Number Of Option Trades = 2 Different Components: Buy 1 call at (X a) strike with expiration date Z Sell 2 calls at X strike with expiration date Z Buy 1 call at (X + a) strike with expiration date Z 66

67 x-a x x+a 67

68 Introduction to Equity Derivatives Part 5: Equity Swaps & Dividend Swaps 68 68

69 Equity Swaps: the basics Swaps Equity Leg vs Interest Leg 69

70 Equity Swaps: Equity Return Notional x (Final Initial / Initial) Where: Notional = Agreed size of trade Final = Price of the underlying on valuation date Initial = Price of the underlying on start date Share Swap =Noof Shares x (Final Initial) Equity Leg vs Forward 70

71 Equity Swaps: Interest Return Notional x Interest Rate x Day Count Fraction Where: Notional = Agreed size of trade Interest Rate = Floating Rate or Fixed Rate Floating Rate = Rate for period +/- spread Fixed Rate = A predetermined rate for all periods Day Count Fraction = Fraction used for rate (ie Act / 360) 71

72 Equity Swaps: Price Return vs Total Return What is Price Return? What is Total Return? Standard Defaults: Index & Share Swaps 72

73 Equity Swaps: Price Return Swap Cashflows 73

74 Equity Swaps: Total Return Swap Cashflows 74

75 Equity Swap Periods: Bullet Swap 75

76 Equity Swap Periods: Resetting Swap 76

77 Equity Swaps: Applications Avoid transaction costs (including tax) Avoid locally based dividend taxes Avoid limitations on leverage To get around rules governing the particular type of investment that an institution can hold Banks make money on commissions, interest rate spreads & dividend spreads (risk-neutral position) 77

78 Equity Swap: A Real Life Example Client Situation An Italian corporate wants to buy a 500,000 shares of ENI Spa BUT they don t have enough cash Bank A Solution Client can gain exposure via a swap with nominal of 500,000 Italian Corporate Pays/receives ENI Spa performance + pays dividends Bank A Equity Swap Buyer Pays Libor + 50bp Equity Swap Seller Client doesn't put up capital and pays financing at Libor + 50bp Bank A makes 50bp spread 78

79 Example of a Yield Enhancement Trade Client Situation - Client has cash to invest - Dividend income it generates is tax exempt Bank A Solution - Bank A sells shares to Spanish bank - Spanish bank writes Bank A an equity swap on the shares - Bank A covers short by borrowing from the street at 92% Bank A sells shares Spanish bank Pays/receives performance + 100% of dividends Receives Funding Bank A Client pays cash MOD 92% Borrows shares Lender Client receives Funding Bank A Receives 100% of the dividend but only pays out 92% of manufactured dividend 79

80 Long Total Return Swap with Hedges 80

81 Short Total Return Swap with Hedges 81

82 Dividend Swap Cashflows 82

83 Introduction to Equity Derivatives Variance, Exotics & Correlation 83 83

84 Variance: the basics Variance = Volatility 2 (σ 2 ) Derivatives annualise (x 252 days) the average daily percentage gain/loss in an underlying's price Variance Swaps Variance Options Conditional Variance Swaps 84

85 Variance: Variance Swaps Swap or Forward? Payout = Variance Amount x (FRV 2 - Variance Strike Price) FRV = 100 x N 252 t = 1 N LN P t P t 1 2 Index vs Share Variance Swaps Advantages 85

86 Variance: Variance Swaps Example Example: Spot Vol = 18% Vega = 10,000 Variance Amount = Vega/(100x2xSpot Vol) = % FRV = 22% Payout = x ( ) = 44,432 FRV = 16% Payout = x ( )= - 63, Final Realised Volatility 86

87 Variance: Variance Options Option vs Forward Payout = MAX[0; Variance Amount x (FRV 2 - Variance Strike Price)] 87

88 Variance: Variance Options Example Example: Desired Strike = 20% (OTM) Spot Vol = 18% Vega = 10,000 Variance Amount = Vega/(100x2xSpot Vol) = Premium = 2000 Final Realised Volatility Strike Price (20%) FRV = 22% Payout = x ( ) = 23,326 Profit = 21,236 FRV = 16% Payout = Zero Profit =

89 Variance: Conditional Variance Swaps Up-Variance Down-Variance Corridor Variance Swaps 89

90 Exotics: Option Payout Formulae Call: Notional x Max [(S K) / R, 0] Put: Notional x Max [(S K) / R, 0] Where: K = Strike Price of the underlying S = Price of the underlying when exercised R = Spot price of the underlying at the time of trade 90

91 Exotics: Funded Options What are Funded Options? Options or Swaps? 91

92 Exotics: Forward Starts & Lookbacks Call Payout: Max(S-K,0) Standard: K = Actual level (ie 5000 or EUR 50) Forward Start: K = Trade Date + 3 months Lookback: K = Min(P1, P2, P3) where P1 = Price of underlying on Date 1 P2 = Price of underlying on Date 2 P3 = Price of underlying on Date 3 92

93 Exotics: Asians Call Payout: Max(S-K,0) Standard: K = Actual level (ie 5000 or EUR 50) S = Price of underlying on Expiration Date Asian In: Asian Out: K = (P / N) OR S = (P / N) where P = Price of underlying on the Asian dates N = Number of Asian valuation days 93

94 Exotics: Composite Composite = Cross Option + FX Fluctuation Risk Example Call on IBM standard payout: $ = No of Options x Max(S-K,0) Call on IBM composite payout: = No of Options x Max(S/Q 1 -K/Q 2,0) where S = $ Settlement Price K = $ Strike Price Q 1 = Prevailing $/ FX rate at time Strike Price taken Q 2 = Prevailing $/ FX rate at time Settlement Price taken 94

95 Exotics: Quanto Quanto = Cross Option - FX Fluctuation Risk Example Call on IBM standard payout: $ = No of Options x Max(S-K,0) Call on IBM quanto payout: = No of Options x Max(S/Q 1 -K/Q 1,0) where S = $ Settlement Price K = $ Strike Price Q 1 = Prevailing $/ FX rate at time Strike Price taken 95

96 Exotics: Out Of Currency Out of Currency = Standard Option + Payout FX Conversion Example Call on IBM standard payout: $ = No of Options x Max(S-K,0) Call on IBM OOC payout: = [No of Options xmax(s-k,0)]/q 2 where S = $ Settlement Price K = $ Strike Price Q 2 = Prevailing $/ FX rate at time Settlement Price taken 96

97 Exotics: Barriers Up-and-out Down-and-out Up-and-in Down-and-in Rebates 97

98 Exotics: Bermudan & Binary Bermudan vs American & European Binary vs Standard Payout 98

99 Exotics: Rainbow Options Worst of/best Of: Min(Perf1;Perf2)/Max(Perf1;Perf2) Call on Best Of: Max (0; Max(Perf1; Perf2)) Put on Worst Of: Max(0; Min(Perf1; Perf2)) Outperformance: Max(0; Perf1 - Perf2) 99

100 Exotics: Correlation Correlation: The Basics Positive Correlation Negative Correlation Dispersions & Correlation Swaps 100