In Part 1 of this three-part product briefing, experienced market practitioners talk about the basics of equity derivatives – including their key features, different types and applications of options, common ways that equity derivatives are used, and the characteristics, uses and risks of capital protection.
Date: Aug 2010
Tags: Derivatives, Structured products, Options, Put option, Call option, Leverage, Yield, Hedging, Volatility, Capital protection, Zero-coupon bond
Building blocks of equity derivatives
Derivatives are products based on underlying assets, and allow investors to take any kind of a view – which, said Garry Frenklah, managing director and head of PIP and equity derivative sales for RBS Global Banking & Markets in South Asia, could be in terms of leverage, protection or timeframe on an underlying instrument.
The decision to get into a derivative position on an underlying equity is determined first and foremost by an investor’s view on that equity, explained Anurag Mahesh, head of global investment services for Deutsche Bank Private Wealth Management in Asia Pacific.
Investors don’t want to therefore get into a derivative position if they are not very constructive on a particular underlying equity or equity index, he advised.
Mahesh added that derivatives can also be used in situations where investors already hold an underlying equity or index, and where they might want to change the risk profile of the underlying – from hedging at one end of the spectrum to monetisation on the other.
The main point, said Adam Cowperthwaite, managing director, head of equity derivatives sales for Daiwa Capital Markets in Asia ex-Japan, is that investors want an exposure one way or another, or have an exposure one way or another, and they want to change that exposure.
When it comes to the building blocks of equity derivatives, Werner Schlossmacher, head of structured derivatives for Credit Suisse Private Banking in Asia Pacific, said it is important to discuss options – with call options and put options being the starting point.
Using options
At the simplest level, investors might look to use vanilla options to enhance leverage. So if investors think a stock is going up in value, they can get much more for their money and a greater return through buying an option rather than buying the stock or index outright, explained Mark Wightman, head of strategy, alternative investments for SunGard in Asia Pacific.
So if investors are positive about a market in the long run, but are uncertain in the short run, they can choose to buy a call option to get the upside participation, added Schlossmacher.
In the wealth management space, Wightman said equity-linked notes (ELNs) or equity-linked instruments (ELIs) are basic yield enhancement products – which work by selling an equity or an index option, which is a simple structure.
If investors have a more defined view on how the underlying will perform – for example if they think it will go up by a maximum of 20% in one year – the best way to express that view is not generally through buying a call option, since this might be expensive given that the option seller is also giving you upside beyond the 20% increase.
Instead, said Arif Mansuri, co-head of equity structured solutions and third-party distribution for Bank of America Merrill Lynch in Asia Pacific, the right product to express the view would be a call spread.
This is where an investor buys an at-the-money call option and sells an out-of-the-money call option at 120, he explained. The option premium that the investor pays is therefore much lower than would have been paid on a call option, enabling the investor to express their view in a more effective way.
If after one year the underlying is up 15%, the investor in a call spread gets paid out 15%, said Mansuri, with anything beyond a 20% upside retained by the option seller.
On the other hand, said Schlossmacher, an investor might expect to see a sideways market. In these cases, an investor who might be happy to hold that particular underlying if the market goes slightly negative, could view this as an acquisition strategy.
Whereas most people who buy equity derivatives tend to do so either as part of structured product for yield enhancement purposes, or as a way of getting better leverage an exposure to a single name and index, Wightman added that it is important to bear in mind that equity derivatives – through using put options – can give investors a way to hedge portfolios and position themselves better in terms of market downturns.
With put options, he said investors are paying a premium today which allows them to buy the underlying shares or index below today’s market price. They will only be in-the-money, or exercisable, should the market fall.
As an example, Cowperthwaite said that if an investor has a position in a single stock but is concerned about the downside risk of that stock, then they can buy a put option in order to negate the downside risk of the stock.
As a further example, Mansuri said that if investors think a particular stock won’t fall more than 25%, they can buy a put spread rather than an outright put.
For investors with large, diversified portfolios, and are interested in achieving some insurance for that portfolio, they could buy some long out-of-the-money put options, said Cowperthwaite, explaining that these wouldn’t cost them too much and would look like insurance.
For this, investors pay a premium to be secured against an event which might or might not occur in the future.
While it is not an exact hedge for a portfolio, it might make up for some losses in the event that a downturn happens, said Cowperthwaite.
According to Mahesh, if investors are looking at a particular equity that they might hold, they might be concerned that despite holding a lot of equities there might be some upside left. In this instance, he explained, they could look to sell a covered call, slightly out-of-the-money from current levels. This could be done either for a part of the amount of equities that investor hold, or for the whole amount – depending on an investors’ view.
If the stock then rallies beyond the strike price of the covered call, Mahesh said investors are obligated to sell their stock, so limiting their potential to the difference between the current price of the stock to the point when they actually sold the covered call. The bank gives the investor an option premium, which they can keep no matter what happens.
If the stock price falls, he said investors wouldn’t benefit or lose any incremental money versus if they have not entered into any derivative position.
This, he said, is an example of a monetisation strategy, not necessarily a hedging strategy.
To drill down further, Mahesh said that if a client holds the same stock and also thinks it could rally, but is at the same time concerned about the macro environment and therefore the potential for the stock to fall – the client could buy a put option on the particular stock or index, along with selling a call.
This is normally referred to as a collar strategy, he explained, where an investor could have a zero-cost collar to adjust the strikes, wherein the premium received for selling a covered call exactly equals the premium used to buy a protective put. This means investors know that they will not lose more than from the current spot to the put-option strike level, and they won’t gain more than from the current price level to the call-option price level.
Typically, said Mahesh, this strategy is for clients who have a levered position, or are thinking of keeping a stock – either for dividend yield, or because they think the stock will trade in that band but wants to borrow some money.
This is an example of a hedging-plus-monetisation strategy, he explained, where the monetisation is the covered call and the premium received from the covered call is being used to create a hedging strategy.
In some cases, meanwhile, Wightman said the use of equity derivatives will also be used to give access to products which investors might not be able to access through the underlying equity or index itself.
For example, said Mansuri, if investors want access to India or China A-Shares, they can buy structured notes linked to the local underlyings.
Some more sophisticated investors might also look to use equity derivatives to take a view on volatility. By using straddles and strangles, which are combinations of options, Wightman said it is possible to take a view on whether investors think volatility will stay within a range, or increase or decrease dramatically.
There are also a lot of other equity derivative structures, added Schlossmacher – for example, total return swaps, to get exposure to a certain underlying, which requires a certain funding requirement, but at the same time providing the total return of that equity plus the dividend incomes potentially from that particular underlying.
Exotic options then become possible by adding knock-in and knock-out features and a combination of options, he said.
Common ways to use equity derivatives
According to Frenklah, some of the most popular equity derivative products are warrants, which are listed on a lot of Asian exchanges, including in Hong Kong and Singapore. Structured notes are also popular, he added, as structured funds, which might have an equity derivative component.
When it comes to ELIs and ELNs, which Wightman said are commonly used in the wealth management industry, these are simple, short-dated products, typically of between one to three months.
An investor who has a certain amount of cash might take it out of a deposit investment to purchase an ELN, explained Cowperthwaite, to achieve a yield which is higher than the deposit interest rate. In doing so, he added, the investor takes the risk that if the underlying shares end up below the strike price, then the investor will be delivered the shares at the strike price, and will suffer a mark-to-market loss.
From a client’s perspective, there are only two possible outcomes with ELIs and ELNs, said Wightman. Either the stock ends up above the strike price, in which case the client gets the yield promised plus the initial investment returned. Or the stock ends up below the strike price, so the client gets converted at that strike price into the underlying stock.
Generally, investors need to be comfortable owning that name if they want to take the risks involved in buying these structures.
Capital protection explained
The most common structured products which investors are familiar with are capital guaranteed products.
These are investment products designed to return to the investor, at a minimum, their initial investment notional at the maturity date – or depending on the terms of the product, possibly at an earlier date – plus some kind of investment return, which could be yield or growth.
Not every client or investor wants participation directly into equity, or whatever is underlying, said Mansuri, so they keep their money in cash. A capital protected product sits somewhere between an investment in a fixed interest instrument and an equity, he explained – it can be viewed as providing investors with peace of mind that they will get their capital back at maturity plus participation in an underlying which they might not have invested in if it were not capital protected.
Mahesh said there are two things going on with capital protected products which are important to explain to clients. First, the client is in most cases buying a zero-coupon bond issued by the bank issuing the product. The second part is the optionality or derivative embedded on the underlying – whether a stock, an index or a basket of stocks.
Effectively the return is generated by the optionality, he explained.
For example, said Mansuri, on a five-year product, perhaps 70% to 80% (depending on the current interest rate) of the capital will be put into a zero-coupon bond which will mature after five years at 100. The remaining amount is invested in a call option payout, and after five years – depending on the movement on the underlying – the option pays out.
So this creates the capital protection from the bond and the upside from the derivative, he said.
However, there are a lot of misunderstandings about participation rates, said Frenklah. In the case of a simple static option, he explained, if investors have 10% to buy the option but the cost of the option is 20%, this means they can buy an option with a 50% participation rate.
But just because an investor is receiving 50%, it doesn’t mean that someone else is receiving the rest, he said. It just means that this is all the investor could afford.
For example, if a zero-coupon bond accrues from 90 to 100, and an investor only has 10 to spend on the option (which costs 20), then they have a 100% capital protected product with a participation of 50%. If another zero-coupon bond accrues from 80 to 90, the final product is 90% capital protected, but the investor then has 20 to spend on the option, so can now get 100% participation.
In terms of risks, Cowperthwaite said the main one with capital guaranteed products relates to who the issuer is. As the financial crisis showed, not all issuers are equal, so credit risk has come to the fore as a result.
This means a product is either capital protected or principal protected (different jurisdictions use the term differently) in as much as the principal is creditworthy, added Mahesh.
So if there is a credit event on the issuing bank, then effectively the capital or principal protection no longer exists, he explained.
The second risk that Cowperthwaite said investors should consider relates to what their intentions are in buying the product. For instance, he asked, do they realistically intend – and can they within their financial circumstances be reasonably sure – to hold the product until maturity?
Given that most capital guaranteed products are intended as buy-and-hold products, he said the risk in exiting early could be that the product might not have performed in the way investors had expected at the outset.
The performance of an embedded option within a capital guaranteed product will not necessarily be in line with the market mid-term, so investors might not be able to apply the payout profile to the current market performance half-way through the life of a capital guaranteed product, and then receive that performance if they unwind early.
Typically, said Mansuri, capital protected structures are most suitable for fixed income investors who haven’t really invested directly into equities, and might be nervous to do so.
For example, said Cowperthwaite, an investor might buy a capital guaranteed product today, at current market rates, linked to a basket of indices, with a five-year maturity, but then only hold the product for two-and-a-half years. At that point, interest rates might have risen, markets might have performed well, and the investor asks for a price.
The price is calculated as the present value of the capital guaranteed portion plus the value of the option. Yet the present value of the capital guaranteed portion will have been affected by the rise in interest rates, explained Cowperthwaite, so might have fallen below the present value on the start date. And the value of the option, despite markets having performed well, might not necessarily have risen – and certainly not in line with the performance of the underlying indices.
This is because of numerous market factors, such as volatility, falling time to maturity, and correlations between the markets, he said.
The investor might therefore find that the valuation of the capital guaranteed product at the point they want to sell it might not match with their expectations give the market performance.
That was frequently the case just before the financial crisis, explained Cowperthwaite, when investors were looking for valuations in capital guaranteed products and couldn’t understand why they hadn’t risen 50% in value, for example, to match the increases in the underlying indices.
In many cases, Mahesh said private banks ask clients to view the products differently – one is a fixed income product and the other is an equity product.
For the fixed income side, he said it is important to discuss with clients whether they want to take an interest rate view for the tenor of the product, or, if they think rates might rise, whether they instead just want to buy the optionality.
If clients are more negative on the markets in general, Mahesh said it might make more sense for them just to buy the zero-coupon bond rather than the optionality.
It is also important to have a discussion around which issuer the client is comfortable with and wants to take on, he added, as the return of capital is determined by the creditworthiness of the issuing bank, with the return on capital being what the derivative is giving the client.
