(Derivatives Consulting Group) Introduction To Equity Derivatives

Introduction to Equity Derivatives
© February 2008 - The Derivatives Consulting Group Ltd

www.dcgconsultants.com
C
Course Agenda
A d
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

Course Agenda
Part 4: Options
• Options
p 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

Part 1: Introduction to Equities

www.dcgconsultants.com 4
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
Stocks and shares: Shareholder rights
• Part ownership
• Voting rights: A vs B shares
• Concept of limited liability
• Dividends
• Common Stock vs Preferred Stock

6
Company Payment Obligations
Company
Employees Premises Taxes & Svcs
Loans Bonds
Dividends on Preferred Shares
Dividends on Ordinary Shares

7
Dividends: the basics
• Why are they issued?
• How are they determined?
• Company obligations re dividends
• Dividend dates: declaration, ex-dividend, record & payment
• Cash
C h vs Stock
St k di
dividends
id d
• Regular vs Extraordinary dividends

8
Corporate actions
• S
Stock
k Splits
S l & Consolidations
C ld
• Mergers & Acquisitions
• Rights Issues
• Bonus Issues (aka Scrip or Capitalisation Issues)
• Spin-offs
• Nationalisation
• g
Delistings

9
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
Mergers & Acquisitions: Top 5 in 2000s
Rank Year Company A Company B Value (USD)
1 2000 AOL Time Warner 164,747,000,000
2 2007 RBS, Fortis, Santander ABN AMRO 95,500,000,000
3 2000 Gl
Glaxo W
Wellcome
ll S ithKli
SmithKline B
Beecham
h 75 961 000 000
75,961,000,000
4 2004 Royal Dutch Shell 74,559,000,000
5 2006 AT&T Inc BellSouth Corp 72,671,000,000

11
Equity Underlyings
• Shares
• Indices
• Baskets
• ADRs

12
Underlyings: Basket Example
Share Share Price Shares of each Share start value
A £10 2.5 £25
B £20 1.25 £25
C £30 0.8333 £25
D £40 0.625 £25
Total: £100 £100

13
Stock Exchanges
Tokyo Stock
Exchange
London Stock
Exchange New York Stock
Exchange

14
Stock Exchanges: the basics
• Products
• Listings
• Primary Market vs Secondary Market
• Open Outcry vs Electronic
• Clearance Systems

15
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 y

16
Stock Exchanges: Black Monday
• DJIA Drops 22.6% (508
points)
• 604.33 million shares traded
( new record)
(a d)
• 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
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
Part 2: Introduction to Derivatives

www.dcgconsultants.com 19
What is a Derivative?
• Definition
• History
• Asset Classes
• Leverage
• Future Settlement

20
Creation of a Derivative
CHOICE
ASSET
CLASSES
INTEREST EQUITIES F/X CREDIT COMMODITIES OTHER

RATES
DERIVATIVE
TYPE
SINGLE BASKET INDEX

NAME
DERIVATIVE
PRODUCTS
FORWARD SWAP OPTION EXOTIC OPTION CORRELATION

21
Derivatives Overview
• Long vs Short
• OTC vs ETD
• Cash vs Physical

22
ETD vs OTC Overview
ETD OTC
Contract Standardised by derivatives Determined on trade-by-
Specifications exchange trade basis between parties
Contract Margin paid into exchange Paid directly between parties
Payments clearing house account
Contract Freely tradable on exchange Unbreakable unless agreed
Flexibility otherwise by parties
Contract Agreement of trade verified Legal confirmation signed
Obligation by exchange between parties

23
Part 3: Forwards & Futures

24 24
Forwards: Contract Specifications
• Number of Forwards
• Forward Price
• Valuation/Settlement Date
• Settlement Terms

25
Forwards vs Futures Overview
Futures Forwards
Contract Standardised by derivatives Determined on trade-by-
S
Specifications
ifi ti exchange
h t d b
trade basis
i bbetween
t parties
ti
Contract Margin paid throughout life Paid directly between parties
Payments of trade into exchange at maturity
clearing
g house account
Contract Freely tradable on exchange Unbreakable unless agreed
Flexibility otherwise by parties
Contract Buyer pays seller current Buyer pays seller agreed
Obligation market price forward price
Contract Agreement of trade verified Legal confirmation signed
Agreement by exchange between parties

26
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
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 shares @ $100 =
• Bank A net + $100
• Bank B obliged to buy shares @ $200 & receives $100 from margin account
• Bank B net + $100
Both banks net the same amount although the cash flows are slightly different

28
Forward Valuation
Forward Price = Spot Price + (Carry Cost – Benefit)
• Basis
• Spot vs Forward Arbitrage

29
Spot vs Forward

30
Forward Trading Example 1
Forward Price = $105 (ie too high)
Today
• Borrow $100 from bank & buy shares now

• Sell forward @ $105
• Deliver shares & receive $105

$
• Receive $2 dividends (total receivables $107)
• Repay the bank your original $100 plus rate @ 5% = $105
• Therefore total = + $107 - $105 = + $2

31
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 forward @ $101
• Receive shares & pay $101

• Give back these shares to lender & pay $2 dividends (total payments $103)
• Withdraw your original $100 from bank plus interest @ 5% = $105
• Therefore total = - $103 + $105 = + $2

32
Forward Price Distribution Graph
• Forward Price distribution
chart assumes that the forward
price will not move outside the
£200-£400
£200 £400 range
• Forward Price Distribution is
centred around its mean

33
Forward Price Distribution Graph (cont’d)
• Shape of “Normal” Distribution

• Normal Distribution is “Bell”
shaped
Forward Trading Example

34
Part 4: Options

35 35
Options vs. Forwards
Forward Price
Forward – Buyer obligated to buy Call Option – Buyer has the right
at Forward Price to buy at Strike Price

36
Options: Contract Specifications
• Option Style
• Option Type
• Number of Options
• Strike Price
• Expiration Date
• Settlement Terms

37
Options: Standard Option Formulae
Call: N x Max (S – K, 0)
Put: N x Max (K – S,
S 0)
Where:
N = Number of Options
K = Strike Price of the Underlying
y g
S = Price of the Underlying when exercised

38
Options: Long Call P&L Graph

39
Options: Long Put P&L Graph

40
Options: Short Call P&L Graph

41
Options: Short Put P&L Graph

42
Option Valuation: the basics
• Option Value = Intrinsic Value + Time Value
• Intrinsic Value
• Time Value
• Volatility
• Length of Time to Expiry
• Other Factors

43
Option Valuation: The Greeks
• Delta
• Gamma
• Vega
• Theta
• Rho

44
Option Strategies: The Basics
• Synthetic Forwards
• Spreads
• Straddles
• Strangles
• Collars
• Butterfly

45
Option Strategies: Synthetic Forwards
• Number Of Option Trades = 2
• Different Components:
Seller
Buyer
Option Type
• Usually Net Premium = 0

46

47

48
Option Strategies: Spreads
• Vertical Spreads
• Horizontal Spreads
• Diagonal Spreads
• Ratio Spreads

49
Spreads: Vertical Spreads
Seller
Buyer
Strike Price
Premium (usually)
( y)

50
Spreads: Bull Call Spread
Example:
• Buy
B 330 St Strike
ik CCallll
• Sell 350 Strike Call

51
Spreads: Bear Call Spread
Example:
• Sell
S ll 310 St
Strike
ik CCallll
• Buy 330 Strike Call

52
Spreads: Put Spreads
Bear Put Spread Bull Put Spread

• Buy 330 Strike Put • Sell 350 Strike Put
• Sell 310 Strike Put • Buy 330 Strike Put

53
Spreads: Horizontal Spreads
Seller
Buyer
Expiration Date
Premium (usually)
( y)

54
Spreads: Diagonal Spreads
Seller
Buyer
Strike Price
Expiration
p Date
Premium (usually)

55
Spreads: Ratio Spreads
• Vertical or Horizontal Spreads
• Other Different Components (ie Number of Options)

56
Option Strategies: Straddles
Option Type
Premium (usually)

57

58

59
Option Strategies: Strangles
Option Type
Strike Price
Premium (usually)

60

61

62
Option Strategies: Collars
Seller
Buyer
Option Type
Strike Price
Premium (usually)

63

64

65
Option Strategies: Butterfly
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
x-a x x+a

67
Part 5: Equity Swaps & Dividend Swaps

68 68
Equity Swaps: the basics
• Swaps
• Equity Leg vs Interest Leg

69
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
p = No of Shares x ((Final – Initial))

• Share Swap
• Equity Leg vs Forward

70
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
Equity Swaps: Price Return vs Total Return
• What is Price Return?
• What is Total Return?
• Standard Defaults: Index & Share Swaps

72
Equity Swaps: Price Return Swap Cashflows

73
Equity Swaps: Total Return Swap Cashflows

74
Equity Swap Periods: Bullet Swap

75
Equity Swap Periods: Resetting Swap

76
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,

commissions interest rate spreads & dividend
spreads (risk-neutral position)

77
Equity Swap: A Real Life Example
Client Situation Bank A Solution
An Italian corporate wants to buy

a 500,000 shares of ENI Spa Client can gain exposure via a swap
with nominal of 500,000
BUT they don’t have enough cash
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

B k A makes
Bank k 50b
50bp spreadd

78
Example of a Yield Enhancement Trade
Client Situation Bank A Solution

- Bank A sells shares to Spanish bank
- Client has cash to invest - Spanish bank writes Bank A an equity swap on the shares
- Dividend income it generates is tax exempt - Bank A covers short by borrowing from the street at 92%
Bank A sells shares
Pays/receives performance + 100%

of dividends
Spanish bank Bank A
Receives Funding
MOD Borrows
Client pays cash 92% shares
Lender
Client receives Funding
Bank A Receives 100% of the dividend but only pays out 92% of manufactured dividend

79
Long Total Return Swap with Hedges

80
Short Total Return Swap with Hedges

81
Dividend Swap Cashflows

82
Variance, Exotics & Correlation

83 83
Variance: the basics
• Variance = Volatility2 (σ2)
• Derivatives annualise (x 252 days) the average daily

percentage gain/loss in an underlying's price
• Variance Swaps
• Variance Options
• Conditional Variance Swaps

84
Variance: Variance Swaps
• Swap or Forward?
• Payout = Variance Amount x (FRV2 - Variance Strike Price)
2
N⎛ P ⎞
252 × ∑ ⎜ LN t ⎟
t =1⎜⎝ Pt −1 ⎟⎠
FRV = 100 x
N
• Index vs Share Variance Swaps
• Advantages

85
Variance: Variance Swaps Example
Example:
• S
Spot VVoll = 18%
• Vega = £10,000
• Variance Amount = Vega/(100x2xSpot
Vol) = 277.7
• FRV = 22%
• Payout = 277.7 x (222 – 182) = £44,432
18%
• FRV = 16%
277 7 x (222 – 162) = -£63,316
• Payout = 277.7 £63 316
Final Realised Volatility

86
Variance: Variance Options
• Option vs Forward
• Payout
y = MAX[0;
[ ; Variance Amount x (FRV
( 2 - Variance Strike Price)]
)]

87
Variance: Variance Options Example
Example:
• Desired Strike = 20% (OTM)
• S
Spot V
Voll = 18%
• Vega = £10,000
• Variance Amount = Vega/(100x2xSpot
Vol) = 277.7
e u =£
• Premium £2000
000
• FRV = 22%
• Payout = 277.7 x (222 – 202) = £23,326
Strike Price (20%) • Profit = £21,236
• FRV = 16%
• Payout = Zero
Final Realised Volatility • Profit = -£2000

88
Variance: Conditional Variance Swaps
• Up-Variance
• Down-Variance
• Corridor Variance Swaps

89
Exotics: Option Payout Formulae
Call: Notional x Max [(S – K) / R, 0]
Put: Notional x Max [(S – K) / R,

R 0]
Where:
K = Strike Price of the underlying
S = Price of the underlying when exercised
R = Spot
p p price of the underlying
y g at the time of trade

90
Exotics: Funded Options
• What are Funded Options?
• Options or Swaps?

91
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
y g on Date 1
P2 = Price of underlying on Date 2
P3 = Price of underlying on Date 3

92
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: K = ∑(P / N) OR

Asian Out: S = ∑(P / N) where
P = Price of underlying
y g on the Asian dates
N = Number of Asian valuation days

93
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/Q1-K/Q2,0) where
S = $ Settlement Price
K = $ Strike Price
Q1 = Prevailing $/£ FX rate at time Strike Price taken
Q2 = Prevailing $/£ FX rate at time Settlement Price taken

94
Exotics: Quanto
• Quanto = Cross Option - FX Fluctuation Risk
Example
Call on IBM quanto payout: £ = No of Options x Max(S/Q1-K/Q1,0) where
K = $ Strike Price
Q1 = Prevailing $/£ FX rate at time Strike Price taken

95
Exotics: Out Of Currency
• Out of Currency = Standard Option + Payout FX Conversion
Example
Call on IBM OOC payout: £ = [No of Options xMax(S-K,0)]/Q2 where
K = $ Strike Price
Q2 = Prevailing $/£ FX rate at time Settlement Price taken

96
Exotics: Barriers
• Up-and-out
• Down-and-out
• Up-and-in
• Down-and-in
• Rebates

97
Exotics: Bermudan & Binary
• Bermudan vs American & European
• Binary vs Standard Payout

98
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
Exotics: Correlation
• Correlation: The Basics
• Positive Correlation
• Negative Correlation
• Dispersions & Correlation Swaps

100

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Introduction to Equity Derivatives

© February 2008 - The Derivatives Consulting Group Ltd

Part 2: Introduction to Derivatives

Part 3: Forwards & Futures

© February 2008 - The Derivatives Consulting Group Ltd

Part 5: Equity Swaps & Dividend Swaps

Part 6: Variance, Exotics & Correlation

© February 2008 - The Derivatives Consulting Group Ltd

Part 1: Introduction to Equities

© February 2008 - The Derivatives Consulting Group Ltd

• Why do shares get issued?

• How are share prices determined?

• What drives share prices up and down?

• Why do people invest in shares?

© February 2008 - The Derivatives Consulting Group Ltd

• Voting rights: A vs B shares

• Concept of limited liability

• Common Stock vs Preferred Stock

© February 2008 - The Derivatives Consulting Group Ltd

Employees Premises Taxes & Svcs

Dividends on Preferred Shares

Dividends on Ordinary Shares

© February 2008 - The Derivatives Consulting Group Ltd

• Why are they issued?

• How are they determined?

• Company obligations re dividends

• Dividend dates: declaration, ex-dividend, record & payment

• Regular vs Extraordinary dividends

© February 2008 - The Derivatives Consulting Group Ltd

• Mergers & Acquisitions

• Bonus Issues (aka Scrip or Capitalisation Issues)

© February 2008 - The Derivatives Consulting Group Ltd

© February 2008 - The Derivatives Consulting Group Ltd

Rank Year Company A Company B Value (USD)

1 2000 AOL Time Warner 164,747,000,000

2 2007 RBS, Fortis, Santander ABN AMRO 95,500,000,000

4 2004 Royal Dutch Shell 74,559,000,000

5 2006 AT&T Inc BellSouth Corp 72,671,000,000

© February 2008 - The Derivatives Consulting Group Ltd

© February 2008 - The Derivatives Consulting Group Ltd

Share Share Price Shares of each Share start value

A £10 2.5 £25

B £20 1.25 £25

C £30 0.8333 £25

D £40 0.625 £25

Total: £100 £100

© February 2008 - The Derivatives Consulting Group Ltd

© February 2008 - The Derivatives Consulting Group Ltd

• Primary Market vs Secondary Market

• Open Outcry vs Electronic

© February 2008 - The Derivatives Consulting Group Ltd

- Raising capital for businesses

© February 2008 - The Derivatives Consulting Group Ltd

© February 2008 - The Derivatives Consulting Group Ltd

- Restriction of Programme Trading

© February 2008 - The Derivatives Consulting Group Ltd

Part 2: Introduction to Derivatives

© February 2008 - The Derivatives Consulting Group Ltd

© February 2008 - The Derivatives Consulting Group Ltd

INTEREST EQUITIES F/X CREDIT COMMODITIES OTHER

SINGLE BASKET INDEX

FORWARD SWAP OPTION EXOTIC OPTION CORRELATION