Equity Derivatives Explained

M. Bouzoubaa

• Publisher: Palgrave Macmillan
• Year: 2014
• ISBN:
  9781137335548
• Topic: Business
• Subtopic: Finanza d'impresa
• Index: Business

A succinct book that provides readers with all they need to know about the equity derivatives business. It deals with vanilla equity products, their usage, structuring and their risk management. The author efficiently bridges the gap between theory and practice, constantly linking risk management tools with specific business objectives.

1	Fundamentals

1.1 Stock Markets and Indices

The most traditional way for companies to raise funds and invest them in profitable new projects is through the introduction of shares in the primary market. Stock exchanges are used as channels to sell shares of ownership of the company through Initial Public Offerings (IPOs); these shares can then be exchanged and traded in secondary markets. Liquidity is an important parameter of stock exchanges as it enables market participants to quickly and easily buy and sell the equity instruments they invest in.

Stocks are listed in exchange-traded (also called “listed”) markets; but equity derivatives can be traded in not just those markets but also in over-the-counter (OTC) markets. Here, we discuss the main features and particularities of these two markets. Exchange-traded markets are organized and regulated, and only standardized financial contracts are listed; on a stock to be traded there can be only a fixed list of options, with predetermined strikes and maturities.

If an investor would like to buy a call option with a very specific strike and target maturity date, they might not find one with those particular features listed on exchange-traded markets. Therefore, they would need to buy it through an OTC market. In these markets, participants trade directly with each other and enter into customized financial transactions; the contracts are designed and issued by financial institutions to make a perfect fit for the needs of investors.

To draw an analogy showing the difference between products traded on an exchange-traded market and an OTC market: If you decide to buy a shirt from a shop, you will only find a range of standardized colors, sizes and styles; this is similar to trading in listed markets. But if you have a very clear idea about the type and style of shirt you want to buy, and you decide to tailor-make it to suit you, that is similar to trading in OTC markets.

Apart from the structural features of the listed and OTC markets, there is a very important difference with regard to the nature of risk between these two markets. Bear in mind that OTC markets are less regulated and exhibit more credit and counterparty risk for investors than listed markets. This is mainly due to the fact that OTC market participants directly face each other through less standardized contracts; this chapter will give a more detailed explanation of the concepts of credit and counterparty risks. Also, most of the sophisticated and complex equity derivatives are traded in OTC markets.

As its name implies, a stock index can be viewed as a formula that provides a representative market return. The most commonly used weighting schemes for stock indices are price-weighted, value-weighted and float-weighted. Here, we briefly discuss their main characteristics and differences as well as their advantages and drawbacks.

A price-weighted index is defined as the arithmetical average of the prices of its underlying stocks. The main advantage of such an index is that it is easy to compute, and there are several other advantages: it can also provide a longer performance record, as a database of historical prices is more widely available, and it can expose several biases such as the greater impact of higher-priced stocks on the index value. However, a price-weighted index implicitly assumes that an investor will hold one share of each stock in the index; but in practice it is rare for investors to follow such a strategy. The Nikkei 225 and Dow Jones Industrial Average are both examples of price-weighted stock market indexes.

A value-weighted index, also called “market capitalization-weighted” index, is computed by summing the total market value of all the underlying stocks composing the index. Each total market value is calculated as the current stock price times the number of shares outstanding. This index weighting scheme assumes that an investor holds each company in the index according to its relative market value weight. Value-weighted indices are better representatives of changes in aggregate wealth. However, the primary bias of value-weighted indices is that firms with higher market capitalization have a greater impact on the index. France’s CAC 40 index is an example of market value-weighted indices.

The S&P 500 index also used to be calculated as a value-weighted index, but has been changed to a float-adjusted weighting. A free float-adjusted market capitalization index can be considered as a subtype of a value-weighted index, as the only difference in the calculation method is replacing the number of outstanding shares with the number of shares that are actually available for trading. The “free-float problem” refers to the fact that many firms have shares that are closely held or not available for public trading. Only firms’ freely traded shares should be included in float-weighted indices.

The float-adjusted index is considered by many market participants as the best weighting scheme, as it assumes that investors hold all the publically available shares of each company in the index. Therefore, it is considered more representative of the market and can be more easily tracked.

Stock indices are not initially intended as a trading vehicle, that is, one cannot buy or sell an index per se. If an investor wishes to gain exposure to a specific market, they can realize a “beta” exposure by investing in tradable instruments designed to replicate this index. (Without entering into too much detail, as this is not the main subject of this handbook, beta exposures can be realized by using index mutual funds, closed-end funds, exchange-traded funds or derivatives.)

1.2 Interest Rates and Dividends

Interest can be defined as a premium paid by a borrower to a lender in compensation for the lender deferring the use of their funds by lending them to the borrower. The interest rate agreed depends on the terms and conditions of the contract signed between borrower and lender. Indeed, the borrowing/lending contract can be a loan, a mortgage, a bond or a more sophisticated contract. The interest rate agreed will depend on the specifications of this contract as well as the creditworthiness of the counterparty, that is the borrower.

Whenever one party lends money to a borrower, the lender bears a credit risk, that is the risk that the borrower will not, whether willingly or unwillingly, fulfill their future obligations under the borrowing/lending contract; the lender is subject to the risk of not getting the agreed future interest or/and principal cash flows. The higher the credit risk borne by the lender, the higher the interest rate.

Credit ratings are used to give an indication of the ability of an entity to meet its current and future obligations under a specified financial transaction. Credit rating agencies such as Standard & Poor’s, Moody’s Investors Service and Fitch Group use the financial history of a company combined with its balance sheet to assess its credit rating. These ratings are then used by a lender to price the interest rate they offer whenever credit risk arises in a transaction with a specific counterparty.

The different types of credit risk include default risk, credit spread risk and downgrade risk. Without going into detail, it may be of interest to know that there are many methods for managing credit risk, including Value at Risk (VaR), limiting exposure to any single debtor, marking to market, using payment netting arrangements, using credit derivatives, setting credit standards, and assigning collateral to loans.

Interest rates are usually expressed as a percentage of the principal for a period of one year. For any given currency, the interest rate will decrease as trustworthiness of the borrower counterparty increases and terms that help control the credit risk are agreed on. In other words, the higher the risk of lending, the higher the cost of borrowing.

Let’s take the case of Metal Limited, a small manufacturing company based in the US that needs US$20,000,000 to finance a profitable new project. The company decides to borrow this principal amount of money from a bank in the form of a five-year maturity loan. The credit grade of this company being quite poor, the bank offers a high interest rate, say 7.5 percent per annum. Metal Limited then evaluates the cost of borrowing versus the return on this new project, expected to be about 12 percent per annum. To maintain the profitability of the project, Metal Limited decides to reduce the cost of borrowing, decreasing the interest rate to be paid to the bank by providing available collateral in the form of land, machines and equipment. The bank then prices the value of this collateral, taking into account its liquidity, and decides to offer a 5 percent annual interest rate.

What is risk-free rate? This could be viewed as the interest rate that rewards Counterparty A for not using its funds in any specific project and lending them to Counterparty B, without bearing any credit risk. To make this situation possible, there should be no doubt about the trustworthiness of Counterparty B in terms of its ability and willingness to repay back its future debt obligations. Traditionally, risk-free rates were derived from Treasury rates – the rates associated with Treasury bonds issued by governments due to the “too big to fail” common belief. However, buying government bonds cannot realistically be considered free of credit risk for any given currency; history has shown that some governments have defaulted on their obligations for political and/or insolvency reasons. The Russian crisis in 1998 resulted in a default on domestic debt; and the 1999/2000 Argentine crisis hit the country’s economy so hard that it caused the government to ...