Epmi - Investment Analysis 09

Executive Programme In Management And Insurance

Investment Analysis Class Notes 9

2009

Prof P. Sen Indian Institute of Management Calcutta

Options Markets

 OTC Markets  Exchanges  Options Clearing Corporation : National Securities Clearing Corporation Limited (NSCCL) – as a middle layer between buyer and seller

Options Trading  OTC Markets  Customized  Comparative low volumes  Higher costs  Exchanges  Most of the trading  High degree of standardization – market participants trade in a limited and uniform set of securities  Contracts involve buying and selling of 100 shares  Adjustments take place for stock dividends and stock splits  Quotations show both “in the money” and “out of money” contracts

Adjustments

 Bonus issue (stock dividend) If ratio is m:n, new strike price = p * n / (n+m)  Rights issue Ration = m:n Issue price = R Old exercise price = X New exercise price = (nX + mR) / (m + n)

Options Trading – Continued  Exchanges (contd)  Normal to see offsetting quotes: higher price for puts would mean lower price for calls.  Discrepancies may occur because of trades taking place at different times  Maturities tend to be relatively short – THREE months. However, for example in the US there can be longer term options too – typically based on larger company securities or indexes – LEAPS (Long Term Equity Anticipation Securities)

 Option Types  Options traded in India are European Options. In the US most of the traded options in the US are American Options, though there are some exceptions – Foreign Currency options and Stock Index options

NSE NIFTY Options • European Style • Trading Cycle: 3 month trading cycle – the near month (one), the next month (two) and the far month (three)

• Expiry Day: Last Thursday of the expiry month. If the last Thursday is a trading holiday, then the previous trading day.

• Permitted Lot Size: 200 • Strike Price Interval: 10

Options Trading – Option Clearing Corporation 1.

Clearinghouse for options trading –owned by the exchanges (NSCCL owned by NSE)

3.

After deal is struck, OCC places itself between the two traders – positioning itself as the effective buyer and seller.

5.

All individuals therefore have to deal only with the OCC

7.

OCC guarantees contract performance.

9.

Margin requirements for writer. The extent is determined by : 

Whether and to what extent the option is trading “in money”. The extent determines the margin needed.



Extent of margin is influenced by other securities in the investor’s portfolio. For example if the call option writer has the underlying stock then that can be held as part of the brokerage account

Options Trading – Type of Options



Index Options http://online.wsj.com/documents/inions.htm



Futures Options



Foreign Currency Options



Interest Rate Options

Reference : http://online.wsj.com/documents/mktindex.htm

Options Trading– Type of Options (contd) “Exotic Options”  Asian Options – (also called an average option) is an option whose 







payoff is linked to the average value of the underlier on a specific set of dates during the life of the option Barrier Options – depend not only on some asset price at expiration but also that it falls below a barrier price • Knock in : exists after a barrier has been achieved • Knock out : ceases to exist after a barrier has been achieved Lookback Options – depends on the maximum or minimum prices during the life of the asset  European Call Payoff : amount by which the final price exceeds the minimum price achieved during life of option  European Put Payoff : amount by which the maximum price achieved during the life of the option exceeds the final price Currency Translated Options – derivative where the payoff is defined in variables in one currency and paid in another  Quanto - fix in advance the exchange rate at which an investment in foreign currency will be converted Binary Options – Discontinuous payoff eg. “All or nothing” – pays nothing if below strike price at time T and pays fixed amount Q if above strike price

Stock Options Microsft ( MSFT ) Expiration

Strike

Oct 5.00 Jul 15.00 Jul 17.50 Jul 20.00 Oct 20.00 Jan 22.00 Jul 22.50 Aug 22.50 Oct 22.50 Jan 22.50 Jan 24.50 Jul 25.00 Oct 25.00 Jan 25.00 Jan 27.00 Jul 27.50 Aug 27.50 Oct 27.50 Jan 27.50 Jan 29.50 Jul 30.00 Oct 30.00 Jan 30.00 Jan 32.00 Jul 32.50 Aug 37.50 *Underlying stock price closing price.

Underlying stock price*: 25.61 Last

Call Volume

Open Interest

Last

Put Volume

Open Interest

20.60 160.00 110.00 ... ... ... 10.50 20.00 285.00 ... ... ... 8.00 250.00 1,515.00 ... ... 20.00 5.50 126.00 4,827.00 ... ... 22,396.00 5.77 3.00 1,420.00 ... ... 6,845.00 4.03 99.00 76,960.00 0.20 150.00 120,060.00 3.10 297.00 13,002.00 ... ... 71,417.00 3.10 1,446.00 3,976.00 0.05 390.00 2,026.00 3.30 188.00 18,422.00 0.15 15.00 6,910.00 3.60 21.00 654.00 ... ... 15,572.00 1.95 165.00 112,060.00 0.60 422.00 187,034.00 0.55 24,015.00 137,827.00 0.05 1,955.00 100,129.00 1.25 1,671.00 94,499.00 0.55 179.00 39,988.00 1.65 1,460.00 40,161.00 0.85 97.00 14,938.00 0.75 1,413.00 285,606.00 1.85 25.00 115,325.00 0.05 121.00 129,998.00 1.95 746.00 7,520.00 0.10 1,092.00 6,127.00 1.95 817.00 6,009.00 0.25 1,536.00 185,820.00 2.10 200.00 12,105.00 0.55 516.00 17,946.00 2.20 22.00 4,371.00 0.25 22.00 72,628.00 4.40 1.00 24,228.00 0.05 10.00 12,129.00 4.50 775.00 2,991.00 0.05 40.00 9,204.00 4.50 31.00 459.00 0.15 260.00 29,466.00 ... ... 681.00 0.10 209.00 142,123.00 6.50 100.00 14,940.00 ... ... 2,290.00 7.00 750.00 203.00 0.05 50.00 ... ... ... ... represents listed exchange price only. It may not match the composite

Options Strategies -1  Comparisons (of Stock Only (A), Call Only (B) and Combination of Call & Bill (C) )  B provides much higher sensitivity to price increases and would benefit the investor with certain beliefs about price increases  C provides a level of insurance  Protective Put (buy stock + buy put)  Provides a form of portfolio insurance. However during price increases profits curtailed by cost of put  Covered Call ( buy stock + sell call → as compared to “Naked Call” which is just the call)  Profit when decision to sell at a certain price – Sell Discipline  Straddle (buy put +buy call)  Apparently payoff always positive – however both a call and put have to be purchased. There is a region of losses  Variations – Strips (2 puts + 1 call), Straps (1 put + 2 calls)

Options Strategies -2  Spreads (Two or more calls (or puts) on the same stock with differing exercise prices or maturity dates –with a combination of buying and selling)  Money Spread – purchase of one option and the simultaneous sale of another with a different expiration date  Time Spread – sale and purchase of options with differing expiration dates  Three price regions. (example of “Bullish Spread” provided in excel sheet – payoff either increases or unaffected by price increase)  Pricing “anomalies” may be a motivation for spreads  Collars (protective put + write call option)  brackets value of portfolio between two bounds  Appropriate for investors who have a wealth goal but are unwilling to suffer a loss beyond a certain level  Some financially engineered products like “equity linked note” are similar to Collars

Put-Call Parity Relationship ST ≤ X

ST > X

Payoff for Call Owned

0

ST - X

Payoff for Put Written

ST – X

0

Total Payoff (C-P)

ST – X

ST - X

Payoff of Long Call & Short Put Payoff Combined = Leveraged Equity

Long Call

Stock Price Short Put

Arbitrage & Put Call Parity

Since the payoff on a combination of a long call and a short put are equivalent to leveraged equity, the prices must be equal. C - P = S0 - X / (1 + rf)T If the prices are not equal arbitrage will be possible If the stock pays dividend, then the general formula becomes : C - P = S0 - X / (1 + rf)T + PV (dividends)

Put Call Parity – Disequilibrium Example

Stock Price = 110 Call Price = 17 Put Price = 5 Risk Free = 10.25% (annual), 5% (semi-annual) Maturity = .5 yr X = 105 Write Call & Buy Put C - P > S0 - X / (1 + rf)T 17- 5 > 110 - (105/1.05) 12 > 10 Since the leveraged equity is less expensive, acquire the low cost alternative and sell the high cost alternative.

Put-Call Parity Arbitrage Cash Flow in 6 Months Immediate Cashflow

ST < 105

ST ≥ 105

Buy Stockd

-110

ST

ST

Borrowa X/(1-r)T=100

+100

-105

-105

Sell Callb

+17

0

-(ST-105)

Buy Putc

-5

105-ST

0

Total

+2

0

0

Position

Notes : a. b. c. d.

r= 5 % semi annual T = 6 months Exercise Price = 105, Sale Price of Option = 17 Exercise Price = 105, Cost of Option = 2 Stock price now = 110

Option-like Securities

• • • •

Callable Bonds Convertible Securities Warrants Collateralized Loans

Futures and Forwards

•

•

Forward - an agreement calling for a future delivery of an asset at an agreed-upon price

Futures - similar to forward but feature formalized and standardized characteristics • Key difference in futures – Secondary trading - liquidity – Marked to market – Standardized contract units – Clearinghouse warrants performance

Forward Contracts vs Futures Contracts

FORWARDS

FUTURES

Private contract between 2 parties

Exchange traded

Non-standard contract

Standard contract

Usually 1 specified delivery date

Range of delivery dates

Settled at maturity

Settled daily

Delivery or final cash settlement usually occurs

Contract usually closed out prior to maturity

Key Terms for Futures Contracts • • • •

Futures price - agreed-upon price at maturity Long position - agree to purchase Short position - agree to sell Profits on positions at maturity Long = spot minus original futures price Short = original futures price minus spot

Types of Contracts • • • •

Agricultural commodities Metals and minerals (including energy contracts) Foreign currencies Financial futures

– Interest rate futures – Stock index futures

Trading Mechanics

• •

Clearinghouse - acts as a party to all buyers and sellers. – Obligated to deliver or supply delivery Closing out positions – Reversing the trade – Take or make delivery – Most trades are reversed and do not involve actual delivery

Margin and Trading Arrangements •

Similar to trading in Stocks, there is an Initial Margin - funds deposited to provide capital to absorb losses and a Maintenance (or Variation) Margin – an established value below which a trader’s margin may not fall. In addition there is a Margin call - when the maintenance margin is reached, broker will ask for additional margin funds

•

Marking to Market - each day the profits or losses from the new futures price are reflected in the account.

•

Convergence of Price - as maturity approaches the spot and futures price converge

•

Delivery - Actual commodity of a certain grade with a delivery location or for some contracts cash settlement

Marking to Market Futures Prices over 5 days : Day 0 1 2 3 4 5

Price 5.10 5.20 5.25 5.18 5.18 5.21

Remark Today

Delivery

Daily Mark to Market Day 1 2 3 4 5

Profit 0.10 0.05 -0.07 0.00 0.03

Daily Proceeds (5,000 X Profit/Loss) 500 250 -350 0 150 550

Cash Vs Actual Delivery  Most Futures contract call for actual delivery  Warehouse receipts  May be settled with higher or lower grade commodities in case of supply constraints – premiums/discounts applicable in such cases  Cash Delivery for Financial Futures  For example a contract involving delivery of $250 times the value of the index

Regulations & Taxation • Inter alia limits of price variations • Because of marking to market – current tax rather than deferred tax

Trading Strategies

• Speculation – short - believe price will fall – long - believe price will rise • Hedging – long hedge - protecting against a rise in price – short hedge - protecting against a fall in price

Speculation No. of T-Bonds Current (November) Spot Price

2,000 100.00

Futures price for December

99.50

Speculator's Exp Spot Price in December

98.50

Margin for trading

10.00%

Contract Size Margin

200,000 20,000

Profit if expected price comes true ROI Price Variation

2,000 10.0% in ONE month! 1.0%

Hedging T-Bond Prices in December 98.50

99.50

100.50

Short Hedge (for sellers of assets/ commodities/ services) Bond holdings (value = 2000 * PT) Futures Profit or Loss (short) Total

197,000 2,000 199,000

199,000 201,000 0

-2,000 (Sell Future Now Buy in December)

199,000 199,000

Long Hedge (for purchasers of assets / commodities/ services) Cash Outflow for Purchase Futures Profit or Loss (Long) Total

-197,000 -199,000 -201,000 -2,000

0

2,000 (Buy Future Now Sell in December)

-199,000 -199,000 -199,000

Types of Hedging 



Cross Hedge - Hedging a position using futures on another commodity eg., hedging for bauxite using aluminum. Risk : Is relationship between aluminum and bauxite stable? Portfolio Hedge  Commodity Futures return have been observed to have a negative correlation with stock returns. Some studies have estimated this at -.24.  These future contracts can thus be used for portfolio diversification. Increase of commodity prices will be hedged by a long position on that commodity and would thus be an inflation hedge

Basis and Basis Risk •

Basis - the difference between the futures price and the spot price

– over time the basis will likely change and will eventually converge •

Basis Risk - the variability in the basis that will affect profits and/or hedging performance

A long-short futures position will profit when basis narrows Now Spot price : $291 Futures Price (3 months away) : $296 Basis = $5 Tomorrow Spot price : $294 Futures Price : $298.50 Basis = $4.50 Gain on holding : $3 Loss on short futures : $2.50 Net Gain : $0.50

Types of Hedging (contd) Calendar Hedge

Investor takes a long position in a futures contract of one maturity and a short position in the same commodity – but with a different maturity Example : September Maturity Contract (Long) + August Maturity Contract Short September Price increases by $.05 August price increases by $.04 Net Position : 5 – 4 = $.01 profit