derivatives in equity portfolios - joanne m. hill · 2018. 11. 16. · equity derivatives in...

Derivatives in Equity PortfoliosJoanne M. HillCo-Head of Global Equity Derivatives ResearchGoldman, Sachs &Company

Equity derivatives can be effective in a wide range of strategies and have achieved broadacceptance by market participants. The market has evolved a great deal since the 1970swhen stock options first began trading. Products range from simple replication of anindex to such complex, sophisticated applications as creating synthetic internationalindex exposure to equity-linked notes and swaps on volatility.

A fter 25 years of listed options trading, 15 yearsof listed futures trading, and the growth of theOTC markets, the importance and usefulness ofequity derivatives in portfolio management hasachieved broad recognition.] Pension & InvestmentAge surveys of the major pen.sion funds indicate thatabout 50 percent of the largest 200 pension funds usederivatives in some way but only 10-11 percent ofmoney managers admit to using them. The differ-ence in percentage use is a function of the largenumber of money managers, the fact that mostmoney managers are bottom-up stock pickers ratherthan macro investors, and the fact that many first-level derivatives applications are more top-downthan bottom-up and, therefore, apply perhaps moreto pension funds. Firms that were late to enter thederivatives market are beginning to hire derivativesexperts and combine this expertise with the properinfrastructure-that is, risk-management systemsand the middle- and back-office functions. This trendwill ultimately give derivatives even broader recog-nition by market participants and will promote thesuccessful use of these products.

This presentation is designed to provide a broadunderstanding of derivatives markets and then focuson derivatives applications for equity portfolios. Itexplains such important issues and concepts relatingto derivatives as the evolution of equity derivatives,how products were developed to accomplish strate-gies, index replication, issues relating to futures andoptions, and conditions that affect the level of deriv-atives activity. The section on derivatives applica-

lEditor's Hate: Some data in this presentation have been updated toreflect changes since the seminar date.

4

tions focuses on how derivatives can be used toenhance fund management, implement asset alloca-tion and view-driven strategies, and manage risk. Themain point is to encourage thinking of derivatives notas ends in themselves but as means to an end.

Evolution of Equity DerivativesStrategies involving equity derivatives developedhand-in-hand with new equity products and imple-mentation vehicles. In the early 1970s, the investingworld focused on individual stock selection imple-mented through block trading of specific shares;selection of assets on the basis of portfolio concerns,efficient frontiers, and index funds were appreciatedand studied more in the academic world than bypractitioners.

Index funds are closely connected to the evolu-tion and the development of derivatives. After thefirst index funds started in the mid-1970s, portfoliostructuring based on quantitative principles becamemore important and stock options began trading. The1970s were a great decade for the start-up and growthof covered-call writing because of the flat equitymarket returns-the average annual return on theS&P 500 Index from 1971 to 1980 was only approxi-mately half a percent.

Strong equity market performance and thedivergence of stock and bond returns in the 1980schanged the focus of derivatives. Derivatives strate-gies now centered on achieving exposure to U.s.equities, with applications involving tactical assetallocation and synthetic index funds. Portfolio insur-ance used futures to replicate a put option with thegoal of protecting portfolio gains. Derivative strate-gies primarily involved stock index options and stock

©Association for Investment Management and Research

index futures. Although buying downside protectionusing index options and index futures attracted a lotof interest, one could do it only with dynamic hedg-ing strategies because of the tight position limits onlisted index options and low liquidity. The failure ofportfolio insurance and its perceived connection tothe stock market crash of 1987, plus the newness ofthe markets, led participants to reevaluate the use ofderivatives. Although practitioners were interestedin expanding their use of equity derivatives, the mar-kets had not developed as fast as their interests, andthey realized options were not going to work asplanned. Dynamic hedging fell by the wayside, butsynthetic investing with futures and basket, or port-folio, trading have both survived.

Proponents of derivatives adopted a bunkermentality for a few years; they spent most of theirtime trying to explain to regulators why derivativeswere safe. In the 1990s, however, many new applica-tions were developed. The main events were thedevelopment of international derivative markets andthe growth in fixed-income OTe derivative markets.Competition from international exchanges and thegrowth in futures applications in the foreign marketsspurred many US. institutions to take another lookat derivatives.

The biggest growth in derivatives use in the 1990shas been in global asset allocation strategies. Anotherfactor in the growth of equity deri\'atives was thedevelopment of longl short strategies, which use longindex futures combined with a market-neutral posi-tion that is long a group of "in-favor" stocks and shortstocks that are expected to underperform. OTeoptions and structured notes in equities fill in the gapsof listed derivatives trading and meet more custom-ized needs. In contrast to fixed income, where theamount of OTe swaps and structured notes outstand-ing is greater than the amount of exchange-tradedderivatives, the notional amount outstanding of OTeequity derivative products is a small fraction of thenotional amount of listed equity derivatives.

Products Meet StrategiesDerivative products are used to make existing strat-egies more efficient or to make new strategies possi-ble. Equity derivatives fit into two categories. Thefirst group, stock or portfolio substitutes that havesymmetrical returns, includes baskets, listed futures,and swaps. In this group, the derivatives bear the fullrisk and return of an underlying security or portfolio,but the underlying security's volatility does not affectthe pricing. The second group, optionlike securities,encompasses listed options, OTe options, andmarket-indexed notes, which are fixed-income secu-rities whose coupons andlor final payments depend


Derivatives in Equity Portfolios

on the return of a stock, portfolio of stocks, or marketindex. The volatility of the underlying security is acritical parameter in pricing these derivatives.

Index ReplicationOne of the basic concepts that underlie manyderivatives applications is that they efficiently repli-cate exposure to an underlying index, such as the S&P500, the Nikkei 225, or the Financial Times StockExchange (FTSE) 100. Basic derivative products, suchas stock index futures and total-return swaps, easilyand efficiently replicate the exposure to virtually anyindex or benchmark.

An investor has three ways of owning an indexfund-buy the index, buy the future, or buy the swap.Buying the stocks in an index gives the investor thedividends, the ending value of the index (capitalgains or losses), and any return on lending the stock.The alternative to buying the stocks is to buy a futurescontract and invest in cash-equivalent portfolios-U.s. T-bills or money market securities. Buying afutures contract on the index gives the investor gainsor losses on the future plus the interest income oninvesting the cash (net of initial margin) that wouldbe otherwise used to buy stocks. The interest incomeon that portfolio serves in place of the dividend andoffsets the loss as futures converge to the index levelat expiration.

A swap operates in a similar way, but instead ofthe gains or losses occurring daily as the investormarks a listed futures position to market, the swapbuyer pays interest in exchange for the total return ofthe index at the reset date, which is usually quarterly.The seller of the swap passes the return, or the movein the underlying portfolio, to the buyer and receivesthe interest payment. This return can be with orwithout dividends; the decision is up to the buyerand is reflected in the interest rate. Swap pricing isusually LIBOR plus or minus a spread, quoted inbasis points, reflecting current market pricing andsupply1demand conditions. As with futures, thebuyer typically invests the cash in a money marketportfolio; this portfolio generates the interest withwhich the buyer will pay the dealer for the return ofthe index via the swap. An investor will be indifferentbetween buying the underlying stocks and enteringinto a swap when interest income from the moneymarket portfolio method equals the fixed- or floating-rate payment on the swap.

Futures CharacteristicsFutures contracts produce symmetrical returns andbear the full risk and return of an underlying securityor portfolio. The underlying security's volatility does

5

Derivatives in Portfolio Management

not affect the pricing. Issues to consider in incorpo-rating futures contracts in investment strategiesinclude valuation, liquidity, tracking risk, and thecost advantage of using futures.

Valuation. The fair value of a futures contractequals the index value plus the expected interestincome minus the dividend income. When determin-ing fair value, the relevant time period is the daysbetween settlement of a stock purchase on the day ofthe futures trade and the settlement of a stock sale atexpiration. The key is the period over which theposition needs to be financed by the arbitrageur. Fairvalue is derived from the difference between thedividends earned and the interest income over thattime frame. The opportunity to arbitrage a mispricedfuture by buying stock and selling the future or viceversa is the basis for fair value.

The only uncertainty in the fair value is that inves-tors must estimate dividend points to expiration, butthis estimate can be made with a high degree of accu-racy. Table 1 provides some sample fair basis spreadsand dividend yields for S&P 500 Index futures as of

November 3/ 1997. The interest rate driving futuresarbitrage is best represented by the deposit rate in theglobal markets. Many people wonder why LIBOR isused instead of repurchase agreement (REPO) rates.In fixed-income investing, investors can borrow andlend Treasury securities in the REPO market. To con-duct stock index arbitrage, investors must financestock. 50/ in equities, the primary participants in indexarbitrage are dealer firms that have high credit rat-ings/ low-cost financing, and access to capital. Thosefirms usually use LlBOR or the U.S. Federal Reservefederal funds rate plus a credit spread. LlBOR yieldsare probably the closest thing to the financing ratesthat drive the arbitrage process.

For institutional clients, evaluation of calendar-spread pricing is critical because most people do notgo in and out of a contract within an expiration cycle.Instead, they carry it over several cycles. Clients doat least as many calendar-spread trades as outrightbuying and selling of futures. 50/ investors need toconsider the timing of shifting contracts from oneexpiration to another. For example, Table 1 provides

Table 1. S&P 500 Index Futures Valuation and Activity: November 3, 1997

A. Valuation

Index

Index/FuturesClose Change

ActualBasis

Fair Value (spread)

FairBasis

(spread)

PercentDeviation

versus FairDividend

PointsDividend

Yield

SimpleInterestYield

SettlementDays

Quarterly Compound Yields

Actual Fair Roll ForwardIndex Spread Spread Yield Yield Difference

S&P 500

12/19/97

03/20/98 9.50 9.49 5.99 5.94 0.05

06/19/tJ8 19.30 19.19 6.03 5.96 0.07

09/18/98 28.70 29.23 5.95 5.98 -0.03

c:. Trading ActivityVolume Volume Open

Index (number) ($ millions) Interest

S&P 500 75,770 34,650 201,172

12/19/97 75,349 193,000

03/20/98 354 6,314

06/19/98 57 1,60709/18/98 10 251

B. Calendar Sprmd

S&P 500

12/19/97

03/20/98

06/19/98

09/18/98

91462

924.00

933.50

943.30

952.70

10.94

20.90

21.15

21.10

21.35

919.22 9.38

928.71 18.88

938.41 28.68

948.45 38.08

4.60

14.09

23.79

33.83

0.52 2.34 1.96 5.69 48

0.52 6.20 1.79 5.75 139

0.53 10.12 1.76 5.80 230

0.47 14.04 1.75 5.87 321

Simple Yields

Roll ForwardYield Yield Difference

5.78 5.73 005

5.86 5.79 0.07

5.82 5.86 -om

Note: US dollar interest rates are derived from the Eurodollar futures curve; spot LIBOR rates are used for the period preceding thenearby Eurodollar contract. The "Trading Activity" data for the United States are shown on a one-day lag (two days ago).

6 ©Association for Investment Management and Research


a sample of the fair value calendar spreads for S&P500 Index futures. An investor can determine the fairspread of switching from December to March con-tracts. When the December futures contract expires,the investor will want to consider what is the rightprice to trade the March contract, given the dividendsthat will occur and the interest that could be earnedbetween December and March. The "Simple ForwardYield" of 5.73 percent is the benchmark yield becauseit is the forward rate between the December and theMarch expiration. The implied yield ("Roll Yield") inthe calendar spread (buying December futures andselling March futures) is 5.78 percent, so the calendarspread on November 3,1997, was close to being fairlyvalued for the S&P 500.

Other futures contracts-such as the futures onthe Russell 2000, the S&P MidCap 400, and the Nas-daq 100 indexes-have much larger mispricings inthe nearby contract and calendar spread. The largermispricings in the Russell 2000 occur because thestocks have bid-offer spreads that might be as wideas 150 basis points (bps). Thus, the cost of doingarbitrage has more slippage, and the mispricingrange that occurs prior to the arbitrage that bringsfutures back to fair value is wider than for S&P 500futures. The difference between the forward yieldand the implied yield in the calendar spread for theRussell 2000 is 27 bps. Generally, the arbitrage pro-cess keeps the contract prices in line with the cost oftrading the stocks.

Volume. In a developed futures market, the dol-lar volume of the underlying stocks is typically afraction of the dollar amount that trades in indexfutures. Figure 1 shows average trading volume for

u.s. stock index futures versus NYSE trading volumeand shows open interest. The NYSE trades about $120of futures for every $100 of stocks that trade on theNYSE. The ratio of open interest to the amount offutures trading volume outstanding for the NYSE inthe United States has for some time been about threeto one (that is, unwinding all of the open positionswould take three trading days). In a new market, theratio might be different. For example, DJIA futureshave a lot more trading activity than open interest.Accordingly, institutional use of DJIA futures forlonger-term index replication is still low; most inves-tors appear to use the contract for day trading.

The stock market and the futures market shouldbe thought of as parts of a complete market, but inthe derivatives markets, the daily trading volumerelative to open interest is a lot higher than withinequities. On any given trading day, only 0.4 percentof the outstanding equities trade on the NYSE, so asmall change in the information set or investors' riskpreferences can create significant trading demands.If 0.8 percent or 0.9 percent of outstanding capitaliza-tion suddenly trades in a day instead of 0.4 percent,that increase can easily double NYSE volume andcreate a lot of market pressure.

Global derivatives applications are an interest-ing and growing area of the derivatives market.Futures activity has been growing relative to equitymarket activity in continental Europe and in Japanbut falling slightly in the United States, the UnitedKingdom, and Hong Kong. Table 2 shows the levelof futures and options volume relative to stockmarket volume in major equity markets around the

Figure 1. Open Interest and Average Daily Volume for U.S. Stock Index Futures versus NYSE DailyVolume, April 1982-June 1997

-40

-60

60 ~:.§

40 :5'ft

20 Kl'""'OJC

o~OJ0-

-20 0

979695949392919089

Open Interest(right axis)

87 88

13 40 I 100~ IL~ ~'ft

©Association for Investment Management and Research 7


Table 2. Ratio of Futures and Options Volume toStock Volume, as of December 31, 1997

world. In most cases, the notional amount thatfutures trade is half to one-and-a-half times theamount that stocks trade.

Cost Advantages. The way in which deriva-tives add value to global applications has much to dowith the trading costs of stocks versus the tradingcosts of futures. Table 3 reports estimates of tradingcosts for stocks and futures. The data are conserva-tive; actual costs are often lower than shown. Afteraccounting for taxes, commissions, market impact,and the need to roll the futures position, futurestypically cost 10-20 percent of the round-trip cost totrade equities in most of the major markets. Futureswill be less costly to trade than the equities, especiallyfor an investor who wants index exposure for a yearor less. This cost advantage is one of the reasonsderivatives are used for equitizing cash and tacticaldomestic and global asset allocations, as well as formanaging long and short equity exposure over shorttime periods.

Country

United States

Canada

JapanHong KongAustralia

United KingdomFranceGermanySwitzerlandNetherlands

SpainItalySweden

Futures/Stocks

1.200.121.930.750.990.853.391.77

1.540.811.562.730.36

Options/Stocks

1.08

0.040.920.24

0.300.701.540.840.621.250.400.620.66

OptionsMost option strategies produce asymmetrical returnpayoffs. The value of an option is directly related tothe underlying security's price. But value remainsindependent of judgments about the direction of theunderlying stock price. Option-pricing models for-malize the relationship between the variables thatinfluence option pricing. In addition to option mod-els, investors need to consider the impact of volatilityon option prices, hedging interest, and the role ofOTC options.

Pricing Models. Option-pricing models comeprimarily in two flavors: Black-Scholes models andCox-Ross-Rubinstein models. Black-Scholes modelsuse a continuous time approach with differentialequations, and they work fine for most Europeanoptions, which allow exercise only at expiration.Cox-Ross-Rubinstein models use a discrete timeapproach, use binomial trees, and are critical forAmerican or any options that allow for early exerciseduring the life of the option. Despite the imperfec-tions of the Black-Scholes model, it is probably stillthe basis for most option modeling, especially inequities.

Volatility. A key element of option-pricing mod-els is that expected volatility increases the value of anoption. In November 1997, expectations for highervolatility raised option premiums; index options arethe most widely affected by increases in volatility.Investors use implied volatility derived from quotedoption prices for comparing options much as they usebond yields to compare bonds. Investors cannot eas-ily compare the prices of bonds of different maturi-ties, so they use yields as a common measurement.

Table 3. Round-Trip Comparative Costs of Trading Stocks and Futures, as of December 1997

Cost Factor United States Japan United Kingdom France Germany Hong Kong

StocksCommissions 0.12% 0.20% 0.20% 0.25% 0.25% 0.50°;\>Market impact" 0.30 0.70 0.70 0.50 0.50 0.50Taxes 0.00 0.21 0.50 0.00 0.00 0.34

Total 0.42% 1.11% 1.40% 0.75% 0.75% 1.34%

FuturesCommissions 0.01% 0.05% 0.02% 0.03% 0.02% 0.05%Market impacta 0.05 0.10 0.10 0.10 0.10 0.10Taxes 0.00 0.00 0.00 0.00 0.00 0.00

Total 0.06% 0.15% 0.12% 0.13% 0.12')10 0.15%

Futures as percentage of stocks 14.28 13.51 8.60 17.00 16.00 11.19

Note: Assumes a $25 million cap-weighted indexed portfolio executed as agent and does not include settlement and custody fees. Localindexes: S&P 500, Nikkei 225, FTSE 100, CAC 40, DAX. All contracts except the CAC 40 are quarterly.

"Trader estimates.


Options are available on a stock or index with manydifferent expirations and strike prices, and impliedvolatility is the common denominator. Investors backout implied volatility from option prices similarly tothe way they back out bond yields from bond prices.In determining whether an option is rich or cheap,the reference point is how its implied volatility mea-sures relative to the historical volatility of the stockor index. Also, implied volatility moves in trends orcycles in much the same way yields do. It exhibits apattern of rising or falling levels over several weeksat a time with only minor reversals.

Volatility, like bond yields, also has a term struc-ture. As Figure 2 shows, implied volatility changesover time and often very quickly. On October 24,1997, before the 7 percent market decline on October27, implied volatility was about 21 percent and had aslight upward slope (short-term volatility was lessthan long-term volatility). The stock market declinefollowed by a reversal was hard for traders to dealwith because they had to readjust their hedges, bothin the decline and the rise. Consequently, S&P 500Index option prices significantly increased, to about30 percent implied volatility.

Hedging Interest. Prices of options (impliedvolatility versus historical volatility) have respondedquickly to increased hedging interest, especially in thepast two years since overwriting lost popularity. His-torically, stock volatility in the U.S. market has beenabout 20 percent, but Figure 3 shows that for the 1993-97 period, volatility was 8-9 percent, which was


highly unusual. Note that as historical volatilityincreases, implied volatility moves right with it. Ifoption traders need to hedge a lot of their optionpositions, however, and the only people in the mar-ketplace are the volatility buyers (that is, option buy-ers), implied volatility will move much higher thanhistorical volatility because the option traders take ongreater risk when all the buyers are short volatility.The same happens in a stock when a lot of people wantto buy calls, especially around earnings announce-ments. As Figure 4 shows, in late 1997, compensation(premiums) was available for people who wanted tosell calls and sell puts, because market makers werelimited in the capital they could apply to sellingoptions. Derivatives market participants follow therelationship between implied and historical volatilityto measure the attractiveness of being long or shortoptions-that is, long or short volatility.

OTe Options. OTC options are privately nego-tiated option contracts between two parties thatagree on the underlying stock, stock portfolio, orindex, as well as the strike price, expiration, andexercise style. The purpose of most OTC options is toextend the life of an existing option, have a differentexpiration date, work with a customized basket ofunderlying stocks, or maintain the confidentiality ofa large transaction by executing it with a dealer.

OTC options fill gaps in listed derivatives trad-ing. They might provide access to a market in whichthe dealer is an active participant but to which theclient has limited access. Trading Swiss equity deri-

Figure 2. Term Structure of Volatility for S&P 500 Index Options, October 1997

....'" . ....

-----------------

20L----L---_L- L- ~Nov Dec Jan Mar Jun

--10/30 ...... 10/31 10/24 - - ~ 10/01



Figure 3. Historical S&P 500 Volatility versus Implied Volatility ofAt-the-Money S&P 500 Option

-:'. :'.

..,..- .

Three-Month Implied

~ 16~

.c,ro

~

24,------------------------------,

20-

8 -".'. ....

.' .. . 'Three-Month Historical

412/92 5/93 11/93 5/94 11/94 4/95 lD/95 4/96 lD/96 3/97 9/97

Figure 4. Volatility Spread versus Change in S&P 500 Return

10 50

8 40 C

C 6 30.2~

reduce risk rather than increase it. The greater thevolatility, the more investors want to reduce their risk.

Restrictions on short selling are another reasonfor the growth in derivatives. Investors that cannotshort stocks will instead trade futures or buy puts indeclining markets. In places such as Taiwan andSouth Korea, swaps and futures are used to short theequity markets because the stock loan markets are notdeveloped enough to allow short positions in stocks.

Information. Because most equity derivativesare index based, trading activity increases with thearrival of macroeconomic information. For an indi-vidual stock earnings announcement, investors mightwant to trade with a stock option. Many derivativesapplications are part of top-down approaches, so theoccurrence of a macro event increases trading activity.

Regulatory Environment. The regubtory envi-ronment also influences the amount and types ofderivatives used. For example, investors in Europeare more comfortable with dealer-based markets, soOTC options are more commonly used in Europe,whereas exchange-traded options are favored in theUnited States. Also, some countries have prohibitionson the use of derivatives by certain people. For exam-ple, the CFTC must approve the use of futures by u.s.investors, so U.s. institutions can trade exchange-traded futures directly only in certain markets.

Liquidity PerspectiveThe liquidity of index futures contracts around theworld is often superior to that of stocks. futures tradeon 90 percent of the capitalization of global equityindexes and 82 percent of the capitalization of worldindexes that exclude the United States (MSCI'sEurope/ Australasia/Far East [EAFE] Index, forexample). A total of about $48 billion in stocks tradeseach day in the world, and the total for futures isabout 20 percent greater, approximately $59 billion.As Table 4 shows, the United States accounts for morethan half of global derivatives activity. In Germany,the derivatives market is important; Germany repre-sents 9 percent of global futures volume but only 7percent of global equities volume. Japan and Ger-many are, respectively, the bellwether derivativesmarkets for the Pacific and European regions. In theUnited Kingdom, derivatives use has not prosperedbecause arbitrage is complicated by a lack of efficientconvergence of futures to stock prices at expiration.

The United States dominates global listedoptions markets with about 71 percent of the totalaverage daily options trading volume of $45 billion.The actual percentage of daily trading is higher whenOTC options are also considered. Markets outside the


Oeriuatives in Equity Portfolios

Table 4. Liquidity Perspective: Percentage ofGlobal Trading in Listed Equity IndexDerivatives, December 31, 1997

Country Stocks Futures Options

Australia 1," 1(;i O(){)'" "France 1 3 2Germany 7 9 6Hong Kong 6 3 2

Japan 7 11 7Other Asia 2 1Other Europe 9 9 7

United Kingdom 7 5 5United States 60 57 71

United States, however, make more use of OTCoptions than listed index options.

With the liquidity in the futures and optionsmarkets, investors can set up synthetic index fundsor use futures for global country allocation strategies.For example, if a large pension fund plans to hireportfolio managers next year to manage a $1 billionglobal equity portfolio and starts shifting andincreasing international investment, the fund manag-ers may prefer to create this exposure now and thenunwind it as they hire managers. They need to knowwhich markets have enough liquidity to handle a $1billion position. Another investor might want toimplement a global asset allocation strategy and needto trade $100 million in a shift. Table 5 shows thepercentage of a day's volume and the percentage ofa day's open interest affected by setting up a $1 billionsynthetic index fund globally or doing a $100 milliontrade in these markets. With a few exceptions, a $1billion synthetic index fund represents a smallfraction of daily trading activity and open interest. Inthe major options and futures markets, $100 millionis less than 10 percent of a day's volume and a verysmall percentage of open interest. For smallerEuropean markets, a shift of $100 million wouldbegin to absorb significant liquidity, but for mostlarge markets, it is a modest trade.

Note that, although the Canadian market hasgrown significantly from what it was several yearsago, it still reports less activity in listed derivativesthan some of the other major global markets. HongKong and Italy are also doing more and more businessin derivatives, although they are not in the top group.

As Table 6 shows, the notional amount of futurescontracts is distributed along similar lines as marketcapitalization, except that Germany has a muchlarger derivatives presence than its capitalizationwould suggest. Germany has 11 percent of globalopen interest, but its equity market has only 4 percentof global market cap.

11

Note: Weights based on December 31, 1997, Financial Times/S&P Actuaries World Index capitalizations. Volume and open interest as of same date.

"Weight for Japan combines weights for TOPIX and Nikkei 225.

Global Asset Allocation($100 million)

-"N

@»(f)(f)

o()

~.

0·::J

Q::J<CD(f)

3"CD3-s::PJ::JPJ

Table 6. Market Capitalization and OpenInterest in Listed Equity IndexDerivatives, December 31, 1997(percent of world)

Market OpenCountry Capitalization Interest

Australia 1(1~) 3(1r)

France 3 3Germany 4 11Hong Kong 2 2

Japan 12 26Other Asia 0Other Europe 12 7United Kingdom 11 6United States 55 42

Derivative StrategiesDerivative products are effective tools that can makeexisting strategies more efficient or can make newstrategies possible. They have four general areas ofapplication: efficient/enhanced fund management,asset allocation, active or view-driven strategies, andrisk management.

Enhanced Fund Management. Efficient or en-hanced fund management strategi'es include usingfutures to equitize cash, tightening benchmark track-ing with overlays, futures-related portfolio trading tokeep costs down, enhancing returns from cheapfutures, cash management or market-neutral strate-gies, and synthetic international indexing.

Equitizing cash. Futures provide an efficientway to maintain strategic asset-class weights, or afully invested position. Equitizing cash appeals to

Derivatives in Equity Portfoiios

investors who require ways to keep cash invested tominimize the unintended risk of the cash flows inpositions. This application, using futures to equitizecash or carry an ongoing position of cash in a mutualfund to provide room for withdrawals, is probablythe most basic and widely used application of equityderivatives. Investment managers can experienceproblems with intermittent cash flows caused bymoney inflows or, worse, large withdrawals in a shortperiod of time, which force the manager to sell stocks.

The cost in basis points of carrying cash increasesas a portfolio's cash allocation increases and as equitymarket returns increase. As Figure 5 shows, with acash allocation of 8 percent, the cost of carrying cashis considerably higher when equity market returnsare 25 percent than when returns are 6 percent-2.0percent per year versus 0.4 percent.

To create the synthetic index (benchmark) expo-sure, the investor simply buys a quantity of contractsbased on the amount of cash to be invested divided bythe notional value of each contact (Index x Multiplier).For benchmarks with no futures contracts, such as theRussell 1000, a combination of other index futures(e.g., the S&P 500 and the S&P MidCap) can be deter-mined that will track the benchmark as closely aspossible. Precise determination of the number of con-tracts involves adjusting for the interest rate sensitiv-ity of daily realized gains and losses, which issometimes called "tailing the hedge."

Tightening benchmark tracking. Benchmarktracking is a big concern because performancemeasurement is increasingly tied to benchmarks.

Figure 5. Using Futures to Equitize Cash

2.5

2.0 ~--------------- ----------- --- ------- -------- -- -----------

Equity MarketReturn at 25(~J~)

------------- ----~--~--- - -7-Equity M~rketReturn atj6'X>

~.r::'f;

'" 1.5UOJ)c:-~

;:

'" 1.0U0

'f;

30.5

o _-co 2 3 4 5

Percent in Cash

6 7 8 9 10


Derivativ"s in Portfolio Management

Managers also worry about tracking benchmarksbecause their compensation is often performancebased. The solution is a simple exercise: For howevermuch cash is taken in, the manager buys a basket offutures to mimic the benchmark for the existingportfolio holding. The manager might construct aportfolio of DJIA futures, Nasdaq 100 futures, S&P500 futures--whatever benchmark or mix of bench-marks has the most similarity to the actual holding.For every $1 million the manager takes in, themanager simply buys $1 million worth of that basketof futures. This approach quickly and efficientlyachieves exposure to the required benchmark.

Futures-related trading. Certain types of port-folio trades tap into the liquidity or ease of dealerhedging from the availability of futures. Portfoliomanagers can lower stock-trading costs throughfutures-related trades. The two most commonly usedfutures-related trades are exchange-for-physical(EFP) trades and basis trades. Futures-related tradesare most commonly used when a portfolio has 5percent or less of tracking error with an index or aportfolio of index futures, although the tracking errorcould be as high as 7 percent or even more. The trildeis much cheaper than trading stocks in a traditionalmanner because it takes advantage of the fact that thedealer can hedge in the derivatives market.

In a typical EFP trade, a fund manager exchangesportfolios for futures (or vice versa) at a spread nego-tiated as a markup or a markdown to the fair valueof the future. Stocks are exchanged at opening orclosing prices adjusted for the spread. The cost isgenerally about 1 cent per share--a little less forselling stock and buying futures, a little more for theother side. This 1 cent cost applies to a portfolio thatis exactly like the S&P 500; for something that has,say, a 3 percent tracking error with the S&P 500, theprice would include a risk premium, so the cost oftracking would be higher. Basically, the dealer at theend of that transaction is long futures/short stocks-or the other way around. This approach is well suitedto transition management and takes advantage of anatural hedge to the dealer. It is also a much cheaperway of trading than when a market maker is neededto make a market in individual stocks.

In a basis trade, a portfolio is exchanged for cash,again at a spread negotiated with the dealer. Clientswho want to buy stocks ask the dealer to quote a pricefor giving them the particular stock portfolio as abasis trade. The dealer who wins buys futures overthe course of the day, with the timing often directedby the client. Then, based on the average futures pricethe dealer paid and the negotiated spread, the dealersells that portfolio to the client. The client neverdirectly takes on a futures position but can takeadvantage of the fact that the dealer is putting on the

14

hedge in the course of the trading day for the com-mitment to give the fund manager the portfolio at theend of the day.

Enhanced equity returns with derivatives. Mostinvestors earn their return enhancement frommanaging the ci1sh available when they establish along position via futures. One approach is forinvestors to buy a cash-equivalent (money market)portfolio, invest the dollar amount in a U.s. orinternational index futures contract, and within thecash-equivalent portfolio, pursue some active strat-egies that add alpha (excess return). Instead ofgetting their alpha from stock picking, they get itfrom cash management or structured fixed-incomeproducts. Another approach is to use market-neutralstrategies, such as long/short or volatility trading.

One of the ways managers can obtain alpha isfrom cheap futures. "Cheap" futures trade belowtheir fair value when financing costs and expecteddividends are considered. As Figure 6 shows, since1982, the deviation of the nearby S&P 500 futurescontract from fair value has historically followed aregular pattern that rarely goes beyond 0.5 percentrich or cheap per month. As Figure 7 shows, S&P 500futures tend to trade below fair value on days whenthe index declines more than one standard deviation.Only in extreme markets is a similar tendency towardrichness found. Thus, declining markets often lead tocheap futures; if the market is falling, an investor hasan opportunity to find some excess return.

Futures will move away from fair value for thefollowing reasons:• Arbitrage. Arbitrage costs will drive the mispric-

ing that investors observe in the marketplace atany time for a futures contract, but other factorsare probably more important.

• Dividend treatment. In some markets, differentgroups of investors get different dividend treat-ment. Most foreign stocks have 15 percent of theirdividends withheld for tax purposes. In localEuropean markets, some investors receive divi-dend tax credits. Futures typically price off of thetax treatment of the local investor. For example, inCermany, the local investor gets 120-140 percentof a quoted dividend yield. Futures in Germanyand similar markets trade very cheaply duringdividend season. So, investors in the UnitedStates, who get 85 percent of German dividends,find advantages in the second quarter of the yearto owning Cerman equities via futures. This pat-tern occurs because domestic investors in Ger-many have the incentive to buy stocks, receivedividend tax credits, and short futures.

Figure 8 shows the cheapness of the Germanfutures depicted in the calendar spread. In thefirst quarter of each year, the futures trades were



Figure 6. S&P 500 Nearby Futures Contract: Deviation from Fair Value, June 1982-August 1997

3

2

~OJ::i

~l-<

';0u..80


Figure 7. Changes in Futures Mispricing Compared with Index Changes,December 31, 1995, to June 20, 1997

18~---------,----------------,------------,Average Mispricing Average Mispricing Average Mispricing

Change: -0.10% Chan e: 0.01% Change: 0.03%

0.8

0.6

0.4 ~o

I

-----+0.2 bI) ~.§ ~'C Co..Co rJ) '.c~ .~Q) (j)coO

~0.2 ~ "E(j) '"u "Cl'-< ~

d: 2-0.4.S en

(j)coc'"-0.66

-0.8

o ~~-1.6-1.4-1.3-1.1-0.9-0.7-0.5 -0.4 -0.2 0 0.2 0.4 0.5 0.7 0.9 1.1 1.3 1.4 1.6 1.8

Standard Deviation (%)

• Return Frequency(left axis)

Change in Percentage Mispricing (right axis):+1 Standard DeviationMean-1 Standard Deviation

Note: Return mean is 0.07 percent; return standard deviation is 0.65 percent.

Table 7. S&P 500 versus Synthetic Index Fund

SyntheticPeriod S&P 500 Index Fund Difference

1992 7.61% 7.69lj~ 0.08%

1993 10.06 9.38 -0.681994 1.31 1.28 -0.031995 37.53 37.54 -0.011996 22.95 22.63 -0.321997 33.35 33.45 0.10

excess of LIBOR) can be "transported" to the assetclass underlying the future or swap. Within theshort-term fixed-income management arena, man-agers who run enhanced index funds, domesticallyor internationally, take on yield-curve risk by extend-ing maturities, assume credit risk, or use mortgage-backed securities with elements of credit and pre-payment risk to enhance yield.

within the range of plus or minus 30 bps a year.Periods of significant richness and cheapness tend topersist for several quarters when they occur andmake running enhanced index funds unattractiveunless the investor gets a lot of alpha from fixedincome. The quarterly returns of a benchmark syn-thetic S&P 500 Index fund for managers who equitizecash or practice synthetic index investing for 1992through 1997 are shown in Table 7. The annualizedmonthly return tracking error over the last threeyears has been about 1.2 percent, but much of thistracking error is noise, as indicated by the muchsmaller annual return differences shown in Table 7.

Return differences from S&P 500 Index results ona monthly basis have recently become larger but aretypically plus or minus 40 bps. As Figure 10 shows,wide swings in one month tend to be reversed thenext month (measured over the period, the correla-tion of these differences was -0.55).

Alternative cash management strategies. Cashheld in synthetic index funds can be invested inshort-term securities or other market-neutral strate-gies. The alpha from these strategies (returns in

Tracking error(five years annualized)

Tracking error(three years annualized)

1.040%

1.239



Figure 8. DAX Calendar Spread Mispricing: January 1,1996, to October 31,1997

6000

5500

5000

4500

4000OJ>Q)

,.-l

3500 >


Figure 9. S&P 500 Futures Calendar Spread (Implied Yield minus EurodollarFutures Yield) versus 30-Year U.S. T-Bond Rate

40,-------------.---------------------,

20

oI-"""--------------"""------L,__---..,.---- ----._-....---__------"''''-------------'--....-------------''''''--------------'~

-60

-80'------------- _

8.0 ,------------~---------------------,

~ 7.52oj

:: 7.0U)

:::] 6.5

3D-Year T-Bond

6.0 '-----__-----'--- --'----__----L ---'----__-----L ---'---- , ,

3/93 9/93 3/94 9/94 3/95 9/95 3/96 9/96 3/97 9/97

Note: The implied yield is the annualized yield earned by an investor long nearby futures and short thefuture expiring three months later. Index and T-bond levels taken on the last business day of the monthprior to expiration.

Figure 10. Difference between Synthetic S&P 500 Index and S&P 500 TotalReturns

0.6,-------------------------..--------------------,

0.4 -

I~ ~ ~ lD l£) l£) L(", In l£) ~ ~ ~ ~ ~ ~ l--.. t'-- t'-- t'-- t'--0-- 0-- 0-- 0-- 0-- 0-- :7- :7- 0-- :7- 2' '" v- :J" :J" C' 0-- :7- 0-- 0-------- ------ ------ ------ ------ ------ ------ ------

-----. "------ ------ ------ ------ ------ ------ ------ ------ ------t'-- 0--

,--< cr, U) t'-- v- cr, lD t'-- :7- rr, lD t'-- 0--

-0.8'----------------~ ~ ~0-- 0-- 0--

------ ------ ------rl (i') t.rJ

-0.6 -

~ 0.2Q)u

~ °!-"'---..-".....---...--"''---mr-'''----''......---..---"'''----'"L-........----..----'''----'''--",----'''-.........--''''--mr'''--",...,.---'''-,.----..rmr-'''----,;.---..-----'''----''''-rnr'''-.........--'''----'''----''''I~0-0.2 -6;:l~ -0.4-c

indexes that have a long history-such as the GermanDAX Index, French CAC 40 Index, and Tokyo PriceIndex (TOPIX)-or a narrower base of more-liquidstocks, as in most European futures indexes. Some dfthese indexes have limited coverage, so portfoliomanagers must be equipped to trade and monitoroverlay positions.

Differences in coverage from benchmark indexescreate tracking error and can create annual returnspre'lds from benchmark indexes of as much as 3--4percent. A synthetic global portfolio using a basketof country equity index futures can diversify some ofthis tracking risk so that deviations from benchmarksare 1-2 percent, depending on the number of futuresin the portfolio. Table 8 contains estimates of trackingerror from BARRA's Global Equity Model and showshow closely an investor can track the FT/S&P-AWIEuroPac using various country combinations offutures contracts. If an investor used nine CFTC-approved contracts, the tracking error is higher thanif 11 different futures contracts were used--1.50percent versus 0.70 percent.

In addition to tracking error, performance mea-surement and attribution in overlay or synthetic coun-try allocation are somewhat complicated. Table 9provides a summary of performance components thataffect returns from synthetic index exposure. Futuresmay require holding excess cash for posting variationmargin, which also can put a slight drag on perfor-mance. To separate the most important of theseeffects, users of futures for managing country expo-


sure may wish to measure performance relative to abasket of futures indexes as well as benchmark coun-try indexes.

Using international derivatives places incremen-tal financial and administrative burdens on portfoliomanagers and firms, not unlike developing a newproduct or strategy. Firms must have processes, pro-cedures, and clear guidelines in place for monitoringexposure and capital at risk. Firms must keep in mindthat certain clients may have restrictions on deriva-tives use. International index derivatives requireongoing management for rolling positions as futuresexpire and for keeping currency exposure in place aswell as for managing the cash representing thenotional amount of the index exposure. Moving fromdomestic to international derivatives also meanschanging from managing S&P 500 futures to manag-ing a portfolio of as many as 11 futures in interna-tional markets, some of which expire at differenttimes (many of them expire monthly). Such a taskrequires extensive trading and settlement resources.

Swaps are an alternative to futures, with manycommon features that firms may find more useful forsynthetic investing in emerging markets.

Because of the international markets' volatility,many investors will want to do their own due dili-gence on these markets-visit the exchanges tounderstand the clearing mechanisms and verify forthemselves that the safeguards are in place.

In short, international investing with derivativesoffers flexibility and lower trading costs but also has

Table 8. Synthetic International Index Fund Allocation Analysis: Futures Baskets Designed to TrackFT/S&P-AWI EuroPac, as of December 31,1997

Futures Optimized Weight as Percentage of Basket

Region/Country Futures Tndex FTWeight 11 Contracts 10 Contracts--_.-~-------------"

Pnc{.fic

Japan TOrTX 26.12% 27.0S";, 27.31%

Hong Kong Hang Seng 3.40 3.82 3.95Australia All Ords 2.79 3.76 3.9·1

Subtotal 32.31°/;) 3466'/0 3')20':;,

EuropeUnited Kingdom nSf 100 2396"/" 2-t45°~, 14.91(~ermany DAX 87~ 933 915

France CAC40 7.410 7.7U 8.18

Switzerland SMI 6.94 7.09 7.33

Netherbnds EOE 525 b.96 6.97Italv MJB 30 365 391 1.39

S\veden OMX 3.00 3.40 .1.87

Spain IBEX 35 2.58 2.50

Subtotal 61.5-1':{, 65.35(~~) 64.S1""Total 93.85\j~) 100.00'\, 100GO%

BAi\RA annualized tracking error O.70'!,'u G80':"


9 CFTC Contracts

28.13%

3.87

4.0236.02%

13.779.63

3923.78

3.20

1.50%

8 CFTC Contracts

28.44(;/0

4.03

4.25

36.72':"

30.40""13.64

1O.31l

4.54

440

100.01l':';,

19


Table 9. Optimal Synthetic Index Exposure:Performance Components

± Tracking errorCountries usedCountry local indexes versus benchmark indexes

± Cost/benefits of rolling futures

± Futures mispricing cost/benefit

± Return on cash and currency management

+ Trading cost savings

+ Tax effects of dividend versus interest income

+ Stock custody and clearing charges

No returns from lending stocks

a lot of moving parts-tracking error and other draw-backs that should be weighed against the trading costsavings and other advantages-so investors shouldgain an understanding of the expertise and resourcesrequired prior to strategy implementation.

Asset Allocation. Derivatives can be used toaccomplish virtually any asset allocation strategy fordomestic, international, and global portfolios. In aninternational setting, derivative applications includeimplementing decisions about country allocationand using options in tactical asset allocation (TAA)strategies, equity swaps, and equity-linked notes.

Country allocation. To comprehend the flexi-bility of derivatives in international asset allocation,consider how efficiently a portfolio manager canimplement asset allocation shifts between countriesusing stock index futures and currency forwards. Forexample, suppose you are the manager of a $100million portfolio that emphasizes your ability to allo-cate country equities and you want to change theportfolio's existing country weightings. Table 10 out-lines the existing weightings and desired weightings

for each country and indicates the required derivativetransactions to implement the entire rebalancing.

In this case, you want to reduce allocations toJapan and Germany; increase allocations to theUnited Kingdom, France, and Hong Kong; and keepSwitzerland steady. In this hypothetical internationalapplication, if you sell $10 million of TOPIX againstan EAFE portfolio, you get a hedged Japanese equityposition or synthetic cash earning the yen/dollarrate. Then, you must also sell the yen forward toeliminate the Japanese currency risk. Next, you couldbuy stock index futures and the currencies of thecountries or markets in which you want to increaseexposure. This shift is an example of a global assetallocation that can be implemented quickly and effi-ciently with derivatives.

TAA options strategies. Another application ofderivatives for asset allocation is using options inTAA strategies. Many TAA strategies involve a com-mitment to sell if the market moves higher and to buyif it moves lower. This contingent trade is similar toselling a call option or put option against a portfolio.Some strategies that use TAA have incorporated sell-ing calls and selling puts at points where trading islikely. The advantage of this arrangement is that if thetrading point is not reached, the investor keeps thepremium income. The benefit of the commitment totrade enables these strategies to perform better whenthe market is expected to remain in a trading range.This strategy is definitely attractive, but althoughsome investors use it when option volatility is high,the strategy has the possibility of locking investorsinto trading when the asset allocation process callsfor different trades. For example, in trading stocksversus bonds, even though the investor is selling

Table 10. Implementing Country Allocation Decisions

Current Weighting Desired Weighting Change

30(;

stocks, if stock prices rise and bond prices rise fartherthan stock prices, bonds might be the first asset classthe strategy reduces. If the investor is short an optioncommitting him or her to the sale of stocks, the strat-egy could force a transaction in the wrong asset class.

Equity swaps. Swaps are another means ofoverlay investing or shorting of equity exposure.They represent a negotiated agreement between twoparties to exchange capital or total returns for aninterest payment at specific reset dates. Like futures,the notional amount of the investment is free to beinvested in short-term fixed-income securities ormarket-neutral strategies. With swaps, the partieshave potential credit risk exposure to each otherbetween reset dates, but with futures, which aremarked to market daily, the credit risk lasts onlyovernight and is with an exchange. Swaps can also beused in markets with no futures or as a way of tradingin markets to which US. investors do not have easyaccess or have no access, such as Taiwan, Thailand,Korea, and Malaysia. Swaps are also used when theindexes on which futures trade cannot be combinedto create the equity portfolio profile desired by theinvestor. These swaps, specified in terms of specificstocks, can be expensive unless the other side of theswap can be found. The swap level is struck wherethe dealer would trade the stock.

Specific swap applications include a substitutefor futures in markets with no futures, two-sidedexposure trading interest, gaining access to an equitymarket in the face of foreign ownership restrictions,leverage, and customized indexes.• Substitute for futures. Swaps can be used in many

of the same applications as futures. Swaps typi-cally have a term of one year or more and, there-fore, eliminate the need to roll futures; theexpected costs and risks of rolling futures, how-ever, are reflected in the swap cost or spread.From a trading cost perspective, investors con-sider substituting swaps for futures when theyexpect to have a position longer than a year anda half. In that case, the trading costs and thehassle of rolling the futures outweigh the incre-mental up-front cost of doing the swap.

• Two-sided exposure trading interest. A swap can bea win/win situation if two sides can be foundand the dealer acts as intermediary. In someemerging markets in Asia, two-way tradinginterest is regular and swap markets are quiteactive.

• Foreign ownership restrictions. If an investor wantsa long-term core position and cannot own stocksbecause of regulatory restrictions, swaps canachieve the desired exposure. For example,Canadian markets have restrictions on foreign



equity investments, so a Canadian investorcould achieve long-term U.S. equity exposure byswapping the S&P 500 Index return (dividendsand capital gains) for LIBOR plus a spread andkeeping the cash in Canadian debt securities.

• Leverage. Swaps can provide leveraged exposureto a market for active trading accounts, such ashedge funds. Financing stock positions directlycan be costly, and the stock must be held ascollateral for the loan. Engaging in a return swap,such as receiving the return of the German DAXand paying the return of the Japanese TOPIX, isan efficient way of taking a position with cashflows restricted to quarterly reset dates.

• Customized indexes. Investors can achieve expo-sure to customized indexes using swaps. Forexample, an investor might want overlay expo-sure to an index or basket specific to a marketview, such as bank stocks in Japan or "red chip"China stocks traded in Hong Kong.

Equity-linked notes. Equity-linked notes(ELNs) are securities that provide internationalequity exposure in a fixed-income format. Theprincipal is protected, and the final principal pay-ment amount is tied to the move in an index, sector,or basket of stocks. An ELN consists of a zero-couponor low-coupon bond and a call option. In the case ofa zero coupon, the difference between the discountednote price and par is used to buy a call option on anequity index, but the dividend return is usually notincluded in the final principal payment. Fundmanagers primarily use ELNs as a conservativemeans to equitize cash, gain timely and efficientaccess to international or emerging markets in aprincipal-protected format, and establish a coreholding of equities.

Equity index participation rates in ELNs aretypically 100 percent and above. The larger theamount of current income the investor desires, thesmaller the equity participation. The investor typi-cally pays par for the ELN, and higher currentincome raises the value of the fixed-income compo-nent of the structure and reduces the equity partici-pation. ELNs are extremely flexible, and selectedinternational structures can be tailored to remove thecurrency exchange risk.

Active or View-Driven Strategies. Investorswho have an opinion on a stock, on a sector, or simplyon market timing can implement their active strate-gies with derivatives. Many applications of single-stock or sector derivatives are based on active views.Derivatives applications include shifting market/benchmark exposure, short-term stock/sector callsales (bearish/neutral), volatility trading, and usinga note with embedded single-stock exposure.

21

Derivatives ill Portfolio Mallagemellt

III Shiftillg marketlbellchmark exposure. Investorscan think of shifting exposure as shifting their beta toan industry, to an international market, or to a valueor growth index. Derivatives provide several vehiclesto alter existing exposure.• U.S. Illdex futures or swaps. Futures or swaps on

the S&P 500, S&P MidCap 400, DJIA, Nasdaq100, or Russell 2000 provide moderate to highliquidity and enable investors to offset or createa small-cap bias by selling (buying) medium/small-cap futures and buying (selling) S&P 500or DJIA futures.

• International index futures or swaps. Managers canreduce unwanted country benchmark risk asthey pick stocks by using country index futures,which have good liquidity.

• Value and growth futures or swaps. An overempha-sis or underemphasis on a style can be adjustedby using size and value or growth index futures.Egure 11 shows the range of indexes for whichan investor can use derivatives to adjust small-cap /large-cap and value/growth exposures; themapping is according to the BARRA size andgrowth factors. An investor may not be able todo all the desired trades (large trades, $150 mil-lion a day, cannot be done in the Russell 2000 or

Note: R1 V = RusseJllOOO Value IndexR1 G = Russell 1000 Growth Index5VX = 5&1' Value Index

Source: BARRA U.s. EqUity Model, October 22,1997.

22

S&P MidCap). Because of liquidity constraints,investors can build a basket or a combination ofthese indexes to track most active portfolios.

• Industry index options or swaps. Gaps in industrycoverage can be remedied with a basket of stocksor industry index derivatives. For example, along calli short put position at the same strikeprice provides the same payoff as a basket of theunderlying stocks-in effect, a forward on thisbasket. These strategies make sense for investorswho have concerns about market risk, style, orsector weight and want to shift exposure for upto or less than one year.III Short-ternz stock/sector call sales. Industry and

sector derivatives in the form of index options can beused to implement a research view on a particularindustry or sector. A number of investment researchdepartments, including Goldman Sachs', havefocused their attention on industry perspectives orthemes, and industry index options provide an easyway to implement their views. Leveraging views onthe relative performance of specific securities withinan industry is another use for options and swaps.

The use of derivatives to adjust exposure to par-ticular stocks should be driven, first of all, by the

R2 V = Russell 2000 Value IndexR2 G = Russel] 2000 Growth Indexsex = 5&1' Growth IndexSPX = 5&1' 500 Index


investor's well-researched opinion of the stock and,second, by the pricing of the option on that stock. Astock option strategy should not be done simplybecause an option valuation screen turns up a name.The option strategy is secondary to the view on thestock. For example, in October 1997, the actual andimplied volatility of semiconductor stocks increasedand the stock of Applied Materials, a U.S.-based semi-conductor equipment maker, suffered a decline inprice that could have represented a buying opportu-nity. An investor with a bullish view on AppliedMaterials could have acquired a position at a reducedcost by committing to buy the stock through a put saleand capitalizing on a rise in the premium of theoptions because of the high implied volatility.

Selling calls is also a way of improving theincome yield on stocks that have high volatility andno dividend yield. For example, investors mightwant to own a low-dividend company but want totransform the holding into something that has alower risk profile. Instead of selling the stock, theycan sell a call against a portion of the position andtranslate some of that potential capital gain into anincome yield from the call sale. In a way, selling callsand receiving the premium is like trading off uncer-tain capital gains for an up-front substitute for divi-dend yield. If equity market returns move back to amore "normal" range, enhancing income by sellingupside yields will be an important strategy in theapplication of derivatives in the future.

III Volatility trading. Volatility trading is a newarea that allows an investor to capitalize on a view thatvolatility will rise or fall. The trading can be done atthe index or stock level. For example, after the Asiancurrency crisis in late 1997, implied volatility of indexoptions rose sharply as investors implemented hedg-ing trades and option market makers reacted to a morecostly trading environment for keeping their tradingbooks in balance. This development presented anopportunity for taking a view that the volatility pre-mium in index options was excessive. Investors couldhave sold put spreads or call spreads with high sensi-tivity to a volatility decline to capitalize on the oppor-tunity. Alternatively, they could have sold a "volatilityswap," in which a dealer pays the investor a returnbased on the extent to which actual market volatilityis below a "strike level" for the swap. The strike levelis typically close to the implied volatility in optionswith the same term as the swap. The advantage of theswap structure is that the investor's payoff is basedentirely on the realized volatility, which leaves thedealer with the task of managing the options positionrequired to deliver the payoff.

Many companies exhibit a pattern of rising vola-tility just before an earnings announcement. An



unusually sharp rise could indicate a greater degreeof investor uncertainty. For example, prior to the Sep-tember 16, 1997, earnings announcement for softwareprovider Oracle Corporation, implied volatility ofoptions on Oracle increased to 47 percent-almost 4percent above its three-month average. For investorsinterested in taking advantage of increased volatilitylevels, selling call options could be attractive. If aninvestor had confidence in the earnings numbers com-ing out and was willing to sell the stock at a certainprice, that investor could collect a fee from peoplewho wanted to speculate. When Oracle was at $38,investors could sell a put option with a $40 strike foralmost $1.875. (The day after the earnings announce-ment, Oracle dropped to $36.0625, and it remainedbelow the $40 strike until expiration in October.)

III Notes with embedded single-stock exposure.Applications of derivatives that provide investorsdownside protection are receiving increased interestlately. Of special interest are structured notes andsynthetic convertible securities, which are alterna-tives to owning stocks that effectively supply a floorin declining price scenarios in exchange for fractional(less than full) participation in upside returns.

In summary, derivatives strategy should startwith an investment view. Then, the investor shouldconsider what the strategy or alternative strategieswill do to beta, or equity exposure, and align thatunderstanding with the investment view.

Risk Management. Portfolio managers and riskmanagers use modern portfolio theory as the frame-work within which they operate, but they have dif-ferent objectives and use different tactics. Theportfolio manager's objective is to find the best assetmix given the desired risk-return trade-off and theavailable investments, but the risk manager assessesthe level and drivers of risk in the ongoing investmentprocess. The portfolio manager estimates excessreturn and risk characteristics for a particular timehorizon, but the risk manager measures and decom-poses risk characteristics, focusing on the primarydrivers of existing risks and their interrelationships.

Proper design of a hedging strategy starts withidentifying the risk that needs to be hedged. This stepoften requires understanding the client's short-termview or concerns and any special constraints relevantto the client's situation. In general, the more narrowor specific the risk to be hedged, the more importantthat the characteristics of the hedging vehicle matchthe source of risk. Exhibit 1 provides a summary ofrisks that may need to be hedged and possible hedg-ing instruments. Once the type of risk is identified,the next step is to select an appropriate hedginginstrument. This step often requires analyzing the

23


Exhibit 1. Identifying the Risk to Be Hedged

View or Situation Type of Risk to Be Hedged

Client likes stocks long term but has short-term Broad market exposureconcerns about a broad market correction.

Client has concern that technology sector will Broad-based sector exposureexhibit seasonal slump but wants to retain longexposure in the event that the sector heats up.

Client has a large position in Lucent Technology Specific industry exposurebut is concerned that weakness amongmultimedia networking stocks could pullLucent down.

Client has a large position in a very-low-cost-basis Company-specific exposurestock that is expected to be weak near term.

Possible Hedging Instruments

S&P 500 futures, options, or Depositary Receipts(SPDRs)

S&P MidCap 400 futures, options, or SPDRsRussell 2000 futures or options

Nasdaq-lOO futures or optionsOptions on a broad technology sector indexOptions or futures on a high-technology index

Options on a multimedia networking index (orother narrow-based sector options, dependingon stock to be hedged)

Single-stock optionsSector index options

risk characteristics of the portfolio or stocks beinghedged.

Applications of derivatives for risk managementinclude overlay futures hedges to reduce exposures,option-based hedges (puts, put spreads, and collars),and selling index calls to trade upside potential foryield enhancement.

III Selling futures. Selling futures on the fund'sbenchmark index is the simplest way to reduce mar-ket exposure without liquidating stock positions. Anyoutperformance of the fund's holdings relative to thebenchmark is retained while the futures hedge is inplace. The dollar amount of futures sold in relation tothe size of the fund can be thought of as equivalent toraising cash-that is, creating a synthetic cash posi-tion with a futures position. The return on the syn-thetic cash is typically the yield of a Eurodollardeposit plus or minus any futures mispricing.

III Hedging with put options. Index options havelong been used by pension funds and institutionalmoney managers for locking in gains on portfolios orreducing downside risk over a short period. In con-trast to the futures hedge, hedging with put optionsallows for some participation in upside moves in thebenchmark index. Buying put options reduces down-side risk for a range of index levels below a selectedstrike price. A fund manager who buys an out-of-the-money put option incurs an up-front cost based onthe term of the hedge and volatility premium in theoption at that time. This up-front cost reduces returnsby a fixed amount if the put expires worthless. Putsare favored if the investor is generally bullish but hassome concern that a view could be wrong and thatequity prices could fall significantly.

III Collars. Collar strategies combine the pur-chase of a put with the sale of a call option, therebylimiting the upside participation above the strike ofthe call sold. Collars are most appropriate if the man-

24

agel' expects a trading-range market with somedownside risk.

Investors need to understand the opportunitycost of zero-premium collars in rising market envi-ronments before using them. In selecting a hedgingstrategy, one should not overemphasize the questionof what the up-front costs are. Research has shownthat going from a fully invested equity position toprotecting that position with a zero-premium collar-that is, buying a put/selling a call at an apparent zerocost-can be the beta equivalent of selling as much ashalf the portfolio's equity exposure. This outcome isfine for an investor who wants it, but some investorsthat buy zero-premium collars do not understand themagnitude of the effect on overall exposure. So, acollar is a fine strategy if the investor thinks that atrading range is highly likely and that the downsiderisk is high and the investor wants to significantlyreduce equity exposure on the upside in exchange fordownside protection.

III Selling call options. In an option strategy,whether at the stock, the sector, or the index level, aninvestor who can assign probabilities to the tradingrange and the upside/downside potential can seewhere to focus attention. A call-selling strategy canalso be a good trading-range strategy for returnenhancement and a good strategy for investors whodo not expect much downside risk but who wantsome compensation for limiting their upside poten-tial. In addition to having a desire to enhance returnsin a modest-return environment, the investor shouldassess whether the level of enhancement provided bythe options sale is sufficient in light of expected riskor the likelihood of forgoing return in a rising market.

ConclusionIn order to understand the equity derivativesmarkets, investors should understand the evolutionof equity derivatives, realize that products were


developed to quickly and efficiently accomplishstrategies, and know that index replication is thebasic concept that underlies many derivatives.Knowing the important differences that distinguishfutures and options and being able to identifyconditions that affect the level of derivatives activityhelp the portfolio manager choose the derivativethat best accomplishes the strategy.



Many new derivatives with a wide variety ofapplications were developed in the 1990s. The strat-egies that these instruments implement can bedivided into four broad categories: to enhance fundmanagement, to achieve asset allocation, to imple-ment view-driven strategies, and to manage risk.Investors should think of derivatives as means to anend, not an end in themselves.

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Question and Answer SessionJoanne Hill

Question: When using futuresfor asset allocation on top of anunderlying cash portfolio, how cana fund manager best manage themargin requirements, both initialand variation margin?

Hill: Initial minimum margin isfixed by the exchange (firms mayrequire excess margin) and can beposted in interest-bearing instru-ments (T-bills). We recommendthat, in keeping cash for makingthe daily variation margin pay-ments, investors watch the volatil-ity of the markets on a daily basisand, to minimize the need to holdexcess cash, keep on hand a cashlevel that reflects a daily move oftwo to three standard deviations.

Most investors in the UnItedStates use "single-currency mar-gining" for international futures.They usually clear (settle) theirbusiness with one futures broker(two at most), whichmakeslifealotsimpler than if many brokers wereused. The broker does all the mar-gining in local currencies with theexchanges, but the investors canpost and receive margin in dollars.

Question: Can derivatives beused to construct a five- to seven-year series of forward prices for anequity portfolio?

Hill: Probably not. That is, youcan do anything at a price, butthink about what the dealer has todo to quote you that price.Anything from 5 to 10 years will beexpensive because the dealer hasto consider carrying that position(hedging) and financing it for thatamount of time. Typically, equitydealers charge quite a bit formaking that kind of a commit-ment. In addition, the investorbears the credit risk of the dealer to

make good on that commitmentover the 5-10 year period. Someinsurance companies, however,find long-term commitments to bea more natural fit on their books.Such companies may be involvedin forward pricing of equities,which an investor could consider ifthe investor is comfortable withthe credit issues.

Question: If volatility in theequity markets decreases, willvolatility in options markets auto-matically decrease, or will optionsmarkets lag?

Hill: We have looked at1987 andat 1990 around the time of Iraq'sinvasion of Kuwait to see how longindex options take to adapt tolower volatility. They usually takeat least 3 months and sometimes aslong as 6-12 months. The indexoption premiums take quite awhile to come down, at least 6months. The result is a wide spreadof implied volatility to historicalvolatility for several months after ahigh-volatility episode.

Question: Has historical stockmarket volatility moved greatlyfrom 20 percent?

Hill: Historical stock market vol-atility depends on what window isexamined. For example, historicalvolatility in October 1997 was morethan 30 percent for the month, themost volatile month since 1988.Historical volatility is now in thelow 20s. Implied volatility movedup to 35 percent and now is downin the 25 percent range, but thespread is wider. The averagespread between implied and his-torical volatility in indexes, whichtakes into account the risk of themarket maker hedging option

positions, is about 3 percent. Instock options, the spread is closerto zero because the option marketmaker can diversify among posi-tions and adjust hedges by tradingstocks.

Question: Is your calculation oftransaction costs in Table 3 for U.s.futures pre or post the S&P futuressplit? Will this dramatic increase inthe cost of using futures reduceinstitutional use of this market?

Hill: This issue is a controversialtopic among dealers and custom-ers. The cost of trading futures hashad a long decline over timebecause the index has gone up. Ireduced the cost estimate from 2bps several years ago to 1 bp, andnow it is approximately 1.3 bps.The calculation in Table 3 does notreflect a split in the multiplier.Because the dollar amount is fixedand the index has gone up, thecommission costs of using themarket have gone down a lot.When stocks split, commissions donot split, so why should everybodybe having such a problem with thisfact in the futures world?

A lower multiplier is not likelyto decrease institutional use offutures. The market has had thiscost level before, and it did notimpede the growth of the market.

Question: You mentioned thatthe percentage of stock marketcapitalization trading every day isabout 0.4 percent. Has that per-centage been fairly constant in thepast 20-25 years?

Hill: It has been fairly constant.The number was 0.48 percent in1991 and is now 0.43 percent. InHong Kong and several othermarkets, the amount of trades per


day has also been between 0.4 and0.5 percent. The ratio for bondtrades per day versus bondsoutstanding is similar. We all wantliquidity, but this ratio is a fact oflife for financial assets. With thiskind of ratio, the demands on thefinancial markets can shift a lot inreaction to big news events.Everybody, whether a regulator oran exchange, faces this challenge.The NYSE is installing capacity to

trade five times its daily volumefor this reason.

Question: How could I try totake advantage of the Januaryeffect using derivatives?

Hill: Making a domestic overlayallocation from large cap to smallcap is very simple. Perhaps be-cause of the January effect, youwould want to tilt away from large


S&P 500 stocks into Russell 2000stocks. You could also do this byselling S&P 500 futures and buyingRussell 2000 or S&P MidCap 400futures. The approach is simple ifyou shift between the S&P 500 andthe Russell 2000: For example, fora $10 million shift, you wouldsimply sell $10 million notionalvalue of S&P 500 futures and buy$10 million in Russell 2000 futures.


derivatives in equity portfolios - joanne m. hill · 2018. 11. 16. · equity derivatives in...

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