introduction to equity derivatives -...
TRANSCRIPT
Introduction to Equity Derivatives
© February 2008 - The Derivatives Consulting Group Ltdwww.dcgconsultants.com
C A dCourse Agenda
Part 1: Introduction to Equities
• The Basics• The Basics• Types of Stock• Dividends• Corporate Actions• Underlyings• Market InstitutionsMarket 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
© February 2008 - The Derivatives Consulting Group Ltdwww.dcgconsultants.com
Course AgendaCourse Agenda
Part 4: Options
• Options vs. Forwardsp• 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
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Introduction to Equity Derivatives
Part 1: Introduction to EquitiesPart 1: Introduction to Equities
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Stocks and shares: The basics
• Why do shares get issued?
• How are share prices determined?• How are share prices determined?
• What drives share prices up and down?
• Why do people invest in shares?
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Stocks and shares: Shareholder rights
• Part ownership
• Voting rights: A vs B shares• Voting rights: A vs B shares
• Concept of limited liability
• Dividends
• Common Stock vs Preferred Stock
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Company Payment Obligations
Company
Employees Premises Taxes & Svcs
Loans Bonds
Dividends on Preferred SharesDividends on Preferred Shares
Dividends on Ordinary Shares
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Dividends: the basics
• Why are they issued?
• How are they determined?How are they determined?
• Company obligations re dividends
• Dividend dates: declaration, ex-dividend, record & payment
C h St k di id d• Cash vs Stock dividends
• Regular vs Extraordinary dividends
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Corporate actions
S k S l & C l d• Stock Splits & Consolidations
• Mergers & Acquisitions
• Rights Issues
• Bonus Issues (aka Scrip or Capitalisation Issues)• Bonus Issues (aka Scrip or Capitalisation Issues)
• Spin-offs
• Nationalisation
• Delistings
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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- Reduction of overcapacity in the industry- Synergy of resources - Enlarge brand portfolio ie L'Oréal's takeover of BodyshopCons- Reduced competition and choice for consumers in oligopoly markets- Likelihood of price increases and job cuts - Cultural integration/conflict with new management
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- Hidden liabilities of target entity
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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 W ll S ithKli B h 75 961 000 0003 2000 Glaxo Wellcome SmithKline Beecham 75,961,000,000
4 2004 Royal Dutch Shell 74,559,000,000
5 2006 AT&T Inc BellSouth Corp 72,671,000,0005 2006 AT&T Inc BellSouth Corp 72,671,000,000
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Equity Underlyings
• Shares
• Indices• Indices
• Baskets
• ADRs
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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
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Stock Exchanges
Tokyo Stock Tokyo Stock ExchangeExchange
London Stock London Stock ExchangeExchange New York Stock New York Stock
ExchangeExchange
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ExchangeExchange
Stock Exchanges: the basics
• Products
• Listings• Listings
• Primary Market vs Secondary Market
• Open Outcry vs Electronic
• Clearance Systems
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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- Corporate governance- Creating investment opportunities for small investors- Government capital-raising for development projects- Barometer of the economyy
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Stock Exchanges: Black Monday
• DJIA Drops 22.6% (508 points)
• 604.33 million shares traded ( d)(a new record)
• Previous record set on the previous Friday (338 million shares)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
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Stock Exchanges: Black Monday (cont’d)
Possible Factors
- Share Overvaluation? - Programme Trading? 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
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Introduction to Equity Derivatives
Part 2: Introduction to Derivatives
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What is a Derivative?
• Definition
• History• History
• Asset Classes
• Leverage
• Future Settlement
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Creation of a Derivative
CHOICEASSET
CLASSESCLASSES
DERIVATIVE
F/XEQUITIES OTHERCREDIT COMMODITIESINTERESTRATES
DERIVATIVE TYPE
SINGLE NAME
INDEXBASKET
DERIVATIVE PRODUCTS
NAME
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FORWARD SWAP OPTION EXOTIC OPTION CORRELATION
Derivatives Overview
• Long vs Short
• OTC vs ETD• OTC vs ETD
• Cash vs Physical
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ETD vs OTC Overview
ETD OTC
ContractSpecifications
Standardised by derivatives exchange
Determined on trade-by-trade basis between parties
Contract Payments
Margin paid into exchange clearing house account
Paid directly between partiesPayments clearing house account
Contract Flexibility
Freely tradable on exchange Unbreakable unless agreed otherwise by parties
Contract Agreement of trade verified Legal confirmation signed ContractObligation
Agreement of trade verified by exchange
Legal confirmation signed between parties
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Introduction to Equity Derivatives
Part 3: Forwards & Futures
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Forwards: Contract Specifications
• Number of Forwards
• Forward Price• Forward Price
• Valuation/Settlement Date
• Settlement Terms
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Forwards vs Futures Overview
Futures Forwards
ContractS ifi ti
Standardised by derivatives h
Determined on trade-by-t d b i b t tiSpecifications exchange trade basis between parties
Contract Payments
Margin paid throughout life of trade into exchange clearing house account
Paid directly between parties at maturity
g
Contract Flexibility
Freely tradable on exchange Unbreakable unless agreed otherwise by parties
Contract Buyer pays seller current Buyer pays seller agreed Obligation market price forward price
ContractAgreement
Agreement of trade verified by exchange
Legal confirmation signed between parties
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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 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
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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 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
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Forward Valuation
Forward Price = Spot Price + (Carry Cost – Benefit)
• Basis• Basis
• Spot vs Forward Arbitrage
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Spot vs Forward
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Forward Trading Example 1
Forward Price = $105 (ie too high)
Today
• Borrow $100 from bank & buy shares now• Sell forward @ $105
In one year’s time
• 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
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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• Buy forward @ $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 interest @ 5% = $105
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• Therefore total = - $103 + $105 = + $2
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Forward Price Distribution Graph
• Forward Price distributionchart assumes that the forwardprice will not move outside the£200-£400 range£200 £400 range
• Forward Price Distribution iscentred around its mean
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Forward Price Distribution Graph (cont’d)
• Shape of “Normal” Distribution
• Normal Distribution is “Bell”shaped
Forward Trading Example
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Introduction to Equity Derivatives
Part 4: Options
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Options vs. Forwards
Forward Price
Forward – Buyer obligated to buy at Forward Price
Call Option – Buyer has the rightto buy at Strike Price
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Options: Contract Specifications
• Option Style
• Option Type• Option Type
• Number of Options
• Strike Price
• Expiration Date
• Settlement Terms
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• Settlement Terms
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Options: Standard Option Formulae
Call: N x Max (S – K, 0)
Put: N x Max (K – S 0)Put: N x Max (K – S, 0)
Where:
N = Number of OptionsK = Strike Price of the Underlyingy gS = Price of the Underlying when exercised
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Options: Long Call P&L Graph
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Options: Long Put P&L Graph
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Options: Short Call P&L Graph
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Options: Short Put P&L Graph
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Option Valuation: the basics
• Option Value = Intrinsic Value + Time Value
• Intrinsic Value• Intrinsic Value
• Time Value
• Volatility
• Length of Time to Expiry
• Other Factors
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• Other Factors
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Option Valuation: The Greeks
• Delta
• Gamma
• Vega
• Theta
• Rho• Rho
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Option Strategies: The Basics
• Synthetic Forwards
• Spreads• Spreads
• Straddles
• Strangles
• Collars
• Butterfly
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• Butterfly
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Option Strategies: Synthetic Forwards
• Number Of Option Trades = 2
• Different Components:• Different Components:
SellerBuyerOption Type
• Usually Net Premium = 0
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Option Strategies: Synthetic Forwards
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Option Strategies: Synthetic Forwards
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Option Strategies: Spreads
• Vertical Spreads
• Horizontal Spreads• Horizontal Spreads
• Diagonal Spreads
• Ratio Spreads
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Spreads: Vertical Spreads
• Number Of Option Trades = 2
• Different Components:• Different Components:
SellerBuyerStrike PricePremium (usually)( y)
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Spreads: Bull Call Spread
Example:B 330 St ik C ll• Buy 330 Strike Call
• Sell 350 Strike Call
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Spreads: Bear Call Spread
Example:S ll 310 St ik C ll• Sell 310 Strike Call
• Buy 330 Strike Call
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Spreads: Put Spreads
Bull Put SpreadBear Put Spread• Sell 350 Strike Put• Buy 330 Strike Put
• Buy 330 Strike Put• Sell 310 Strike Put
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Spreads: Horizontal Spreads
• Number Of Option Trades = 2
• Different Components:• Different Components:
SellerBuyerExpiration DatePremium (usually)( y)
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Spreads: Diagonal Spreads
• Number Of Option Trades = 2
• Different Components:• Different Components:
SellerBuyerStrike PriceExpiration DatepPremium (usually)
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Spreads: Ratio Spreads
• Vertical or Horizontal Spreads
• Other Different Components (ie Number of Options)• Other Different Components (ie Number of Options)
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Option Strategies: Straddles
• Number Of Option Trades = 2
• Different Components:• Different Components:
Option TypePremium (usually)
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Option Strategies: Straddles
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Option Strategies: Straddles
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Option Strategies: Strangles
• Number Of Option Trades = 2
• Different Components:• Different Components:
Option TypeStrike PricePremium (usually)
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Option Strategies: Strangles
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Option Strategies: Strangles
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Option Strategies: Collars
• Number Of Option Trades = 2
• Different Components:• Different Components:
SellerBuyerOption TypeStrike PricePremium (usually)
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Option Strategies: Collars
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Option Strategies: Collars
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Option Strategies: Butterfly
• Number Of Option Trades = 2
• Different Components:Different Components:
Buy 1 call at (X − a) strike with expiration date ZSell 2 calls at X strike with expiration date ZSell 2 calls at X strike with expiration date ZBuy 1 call at (X + a) strike with expiration date Z
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x x+ax-a
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Introduction to Equity Derivatives
Part 5: Equity Swaps & Dividend Swaps
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Equity Swaps: the basics
• Swaps
• Equity Leg vs Interest Leg
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Equity Swaps: Equity Return
Notional x (Final – Initial / Initial)
Where:Where:Notional = Agreed size of tradeFinal = Price of the underlying on valuation dateInitial = Price of the underlying on start date
• Share Swap = No of Shares x (Final – Initial)p ( )
• Equity Leg vs Forward
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Equity Swaps: Interest Return
Notional x Interest Rate x Day Count Fraction
Where:Where:Notional = Agreed size of tradeInterest Rate = Floating Rate or Fixed RateFloating Rate Rate for period +/ spreadFloating Rate = Rate for period +/- spreadFixed Rate = A predetermined rate for all periodsDay Count Fraction = Fraction used for rate (ie Act / 360)
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Equity Swaps: Price Return vs Total Return
• What is Price Return?
• What is Total Return?• What is Total Return?
• Standard Defaults: Index & Share Swaps
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Equity Swaps: Price Return Swap Cashflows
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Equity Swaps: Total Return Swap Cashflows
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Equity Swap Periods: Bullet Swap
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Equity Swap Periods: Resetting Swap
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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 aninstitution can hold
• Banks make money on commissions interest rate spreads & dividend• Banks make money on commissions, interest rate spreads & dividendspreads (risk-neutral position)
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Equity Swap: A Real Life Example
An Italian corporate wants to buy a 500,000 shares of ENI Spa Client can gain exposure via a swap
Client SituationClient Situation Bank A SolutionBank A Solution
BUT they don’t have enough cashwith nominal of 500,000
Italian CorporateBank A
Pays/receives ENI Spaperformance + pays dividends
Client doesn't put up capital and pays financing at Libor + 50bpB k A k 50b d
Pays Libor + 50bpEquity Swap Buyer Equity Swap Seller
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Bank A makes 50bp spread
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Example of a Yield Enhancement Trade
Client SituationClient Situation Bank A SolutionBank A Solution
- Client has cash to invest- Dividend income it generates is tax exempt
- 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
Bank A sells shares
Pays/receives performance + 100% of dividends
Bank ASpanish bank
Receives Funding
Client pays cashBorrows shares
MOD92%Client pays cash
Client receives Funding
Lender
shares92%
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Client receives FundingBank A Receives 100% of the dividend but only pays out 92% of manufactured dividend
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Long Total Return Swap with Hedges
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Short Total Return Swap with Hedges
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Dividend Swap Cashflows
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Introduction to Equity Derivatives
Variance, Exotics & Correlation
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Variance: the basics
• Variance = Volatility2 (σ2)
• Derivatives annualise (x 252 days) the average daily Derivatives annualise (x 252 days) the average daily percentage gain/loss in an underlying's price
• Variance Swaps• Variance Swaps
• Variance Options
• Conditional Variance Swaps
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Variance: Variance Swaps
• Swap or Forward?
• Payout = Variance Amount x (FRV2 - Variance Strike Price) Payout Variance Amount x (FRV Variance Strike Price)
N2
tPLN252 ∑× ⎟
⎟⎞
⎜⎜⎛
N1t 1tP
LN252
x 100FRV
∑= −
×
=⎟⎟⎠
⎜⎜⎝
• Index vs Share Variance Swaps
• Advantages
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Advantages
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Variance: Variance Swaps Example
Example:
S V l 18%• Spot Vol = 18%• Vega = £10,000• Variance Amount = Vega/(100x2xSpot
Vol) = 277.7
• FRV = 22%• Payout = 277.7 x (222 – 182) = £44,432
• FRV = 16%Payout = 277 7 x (222 162) = £63 316
18%
• Payout = 277.7 x (222 – 162) = -£63,316
Final Realised Volatility
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Variance: Variance Options
• Option vs Forward
• Payout = MAX[0; Variance Amount x (FRV2 - Variance Strike Price)]y [ ; ( )]
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Variance: Variance Options Example
Example:
• Desired Strike = 20% (OTM)S V l 18%• Spot Vol = 18%
• Vega = £10,000• Variance Amount = Vega/(100x2xSpot
Vol) = 277.7• Premium = £2000e u £ 000
• FRV = 22%• Payout = 277.7 x (222 – 202) = £23,326• Profit = £21,236Strike Price (20%)
• FRV = 16%• Payout = Zero• Profit = -£2000Final Realised Volatility
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Variance: Conditional Variance Swaps
• Up-Variance
• Down-Variance• Down-Variance
• Corridor Variance Swaps
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Exotics: Option Payout Formulae
Call: Notional x Max [(S – K) / R, 0]
Put: Notional x Max [(S – K) / R 0]Put: Notional x Max [(S – K) / R, 0]
Where:K = Strike Price of the underlyingS = Price of the underlying when exercisedR = Spot price of the underlying at the time of tradep p y g
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Exotics: Funded Options
• What are Funded Options?
• Options or Swaps?• Options or Swaps?
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Exotics: Forward Starts & Lookbacks
Call Payout: Max(S-K,0)
Standard: K = Actual level (ie 5000 or EUR 50)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 1y gP2 = Price of underlying on Date 2P3 = Price of underlying on Date 3
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Exotics: Asians
Call Payout: Max(S-K,0)
Standard: K = Actual level (ie 5000 or EUR 50)Standard: K = Actual level (ie 5000 or EUR 50)S = Price of underlying on Expiration Date
Asian In: K = ∑(P / N) ORAsian Out: S = ∑(P / N) where
P = Price of underlying on the Asian datesy gN = Number of Asian valuation days
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Exotics: Composite
• Composite = Cross Option + FX Fluctuation Risk
ExampleExample
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) whereS = $ Settlement Price$K = $ Strike PriceQ1 = Prevailing $/£ FX rate at time Strike Price takenQ2 = Prevailing $/£ FX rate at time Settlement Price taken
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Exotics: Quanto
• Quanto = Cross Option - FX Fluctuation Risk
ExampleExample
Call on IBM standard payout: $ = No of Options x Max(S-K,0)Call on IBM quanto payout: £ = No of Options x Max(S/Q1-K/Q1,0) whereS = $ Settlement Price$K = $ Strike PriceQ1 = Prevailing $/£ FX rate at time Strike Price taken
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Exotics: Out Of Currency
• Out of Currency = Standard Option + Payout FX Conversion
ExampleExample
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)]/Q2 whereS = $ Settlement Price$K = $ Strike PriceQ2 = Prevailing $/£ FX rate at time Settlement Price taken
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Exotics: Barriers
• Up-and-out
• Down-and-out• Down-and-out
• Up-and-in
• Down-and-in
• Rebates
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Exotics: Bermudan & Binary
• Bermudan vs American & European
• Binary vs Standard Payout• Binary vs Standard Payout
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Exotics: Rainbow Options
Worst of/Best Of: Min(Perf1;Perf2)/Max(Perf1;Perf2)
Call on Best Of: Max (0; 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)
© February 2008 - The Derivatives Consulting Group Ltdwww.dcgconsultants.com
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Exotics: Correlation
• Correlation: The Basics
• Positive CorrelationPositive Correlation
• Negative Correlation
• Dispersions & Correlation Swaps
© February 2008 - The Derivatives Consulting Group Ltdwww.dcgconsultants.com
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