outperformance options catley lakeman winter offsite – january 2014

Outperformance Options

Catley Lakeman Winter Offsite – January 2014

Introduction

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Country/region specific views can be implemented via outperformance options.

Within regions, general equity sub-sectors can be included - e.g. Mid Cap versus Large

Cap

Examples of Outperformance Notes include;

Europe over US (or vice-versa)

EM over DM (or vice-versa)

Mid cap over Large cap (or vice-versa)

Exposure to the performance of one index over another (including in the case of both

indices falling)

“Relative Allocation”

Description

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Outperformance is the difference in relative performance of one asset over another.

This is defined as the percentage change since the initial level which is set at the outset of the trade.

I.e. Day 1 both indices are at 100% of their initial level, by definition.

Dec-01 May-03 Sep-04 Feb-06 Jun-07 Nov-08 Mar-10 Jul-11 Dec-12

-70%

-60%

-50%

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0%

10%

20%

30%

FTSE 100 Index Local Currency 5Y Performance - S&P 500 Index Local Currency Performance Spread

S&P outperforms FTSE in these periods

FTSE outperforms S&P in these periods

Pricing Factors of Outperformance Options

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These are the main factors which the price of an outperformance option can be

attributed to, there are others.

The Forwards of the two Indices - the difference between the two forwards is

an important factor.

Volatility

Correlation

Forwards

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Forward Factor Differential

Date Index Current Spot Rate DivYield Forward Factor 5 year Forward

11/12/2013 FTSE 100 6507.72 1.84% 3.62% 91.48% 5953.35

11/12/2013 S&P 500 1782.22 1.60% 2.15% 97.31% 1734.32

Difference -5.83%

Remember: Rates minus Dividends

The Forward of the S&P 500 is greater (5.83%) than that of FTSE 100.

Locking in current forward levels!

Price of an outperformance option of FTSE100 over S&P 500 will be cheaper than that of S&P over

FTSE 100

Outperformance option quotes – *Indicative Composite Quotes

Date Index Price Tenor

11/12/2013 FTSE 100 over S&P 500 6.24% 5 year

11/12/2013 S&P 500 over FTSE 100 12.44% 5 year

FTSE 100...11.4%

S&P 500...15.5%

Vanilla Call premiums (in local crncy)?

Volatility of the Underlyings

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Most circumstances: an increase in Implied Volatility for either of the underlyings results in an

increase in the value of an outperformance option

Why? → Remember we have a call option on the spread of the performance between

two indices, the increase in the volatility of that spread will cause the value of the

option to also increase (most cases) → “Positive Vega”

The blue line shows an increasing volatility regime, this results in the spread between the indices increasing in volatility

Jan-14 Apr-14 Jul-14 Oct-14 Feb-15 May-15 Aug-15 Dec-1540%

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FTSE 100 simulationS&P 500 Simulationvol of spread

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Vol of FTSE 100 is 18.1%Vol of S&P 500 is 19.5%

Simulated Correlation = 0.81 throughout

Vol of FTSE 100 increases 28.1%Vol of S&P 500 remains at 19.5%

The blue line shows an increasing volatility regime, this results in the spread between the indices increasing in volatility

Volatility of the Underlyings

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Other circumstance: High correlation, volatility collapse of one of the indices can lead to an

increase in the value of an outperformance option

Why? → again, the result here is an increase in the volatility of that spread. Example

given below

Both indices move in sympathy (high correlation) but with differing volatility, volatility of the spread is higher.


80%

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Vol of FTSE 100 is 18.1%Vol of S&P 500 is 19.5%

Simulated Correlation = 0.93 throughout

Vol of FTSE 100 remains 18.1%Vol of S&P 500 decreases to 9.8%

Both indices move in sympathy (high correlation) but with differing volatility, volatility of the spread is higher.

Correlation of the Underlyings

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Investors are “short” Implied Correlation between the two indices – i.e. investors benefit from the fall

in the implied correlation of the performance of the two indices.

Why? → again, the result here is an increase in the volatility of the spread. Example

given below


95%

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Correlation = 0.95

Correlation = 0.48

Markets move in a less correlated way... Again, look at the effect on the spread volatility

Fall in Correlation

Correlation of the Underlyings

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Investors are “short” Implied Correlation between the two indices – i.e. investors benefit from the fall

in the implied correlation of the performance of the two indices.

Why? → again, the result here is an increase in the volatility of the spread. Example

given below

-1 -0.8 -0.6 -0.4 -0.2 0 0.2 0.4 0.6 0.8 10%

2%

4%

6%

8%

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12%

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18%

How different correlations affect the price of an Outperformance option

Correlation of Indices

Example:Both indices at 100, Vol(A) = Vol(B) = 20%, 1 year to expiry

©Tom May

Outperformance Note Indicative Prices – UK and US

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Dec-01 Sep-04 Jun-07 Mar-10 Dec-12

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0%

10%

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FTSE 100 Index Local Currency 5Y Per-formance - S&P 500 Index Local Cur-

rency Performance Spread

S&P outper-forms FTSE in these periods

FTSE out-performs S&P in these periods

5Yr UBS FTSE over S&P Outperformance Note

GBP quanto

262% Participation in any outperformance of

FTSE over S&P after 5 year term

Soft capital protection, 60% knock-in , worst-

of.

[Cap protected version: 115% participation]

5Yr UBS S&P over FTSE Outperformance Note

GBP quanto


S&P over FTSE after 5 year term


of.


Initial Sensitivities

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Initial sensitivities of the trade (version with soft capital protection):


GBP quanto

262% Participation in any outperformance of FTSE over S&P after 5 year term

Soft capital protection, 60% knock-in , worst-of.


Sensitivity

...to the underlying Spot moves FTSE 100: 138.1% note positiveS&P 500: -77.4% note negative

Net Delta: 60.7%

...to the change in implied Volatility FTSE 100: -0.29%S&P 500: 0.39%

Net Vega: 0.1%


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GBP quanto




Sensitivity

...to the Correlation between the underlyings

Outperformance options:-0.77% per correlation point

Worst-of KI Put option:+0.17% per correlation point

Net = -0.60% per correlation point

Sensitivity to correlation is at a maximum when both index volatilities are equal


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GBP quanto




Sensitivity

...to the change in interest rates Assuming a 1% move in both USD and GBP rates -2.6% per +1% rate move

Outperformance Note Indicative Prices – EM and DM

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5Yr UBS EEM UP over S&P 500 Outperformance

Note

GBP quanto


EEM UP over S&P 500 after 5 year term


of.

5Yr UBS S&P 500 over EEM UP Outperformance

Note

GBP quanto


S&P 500 over EEM UP after 5 year term


of.

Aug-03 May-06 Feb-09 Nov-11

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EEM UP Equity Local Currency 5Y Per-formance - S&P 500 Index Local Cur-

rency Performance Spread

S&P outper-forms EEM UP in these periods

EEM UP outperforms S&P in these periods

Outperformance Note Indicative Prices – Mid and Large Cap

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5Yr UBS S&P 400 Midcap over S&P 500

Outperformance Note

GBP quanto


S&P 400 Midcap over S&P 500 after 5 year

term


of.

5Yr UBS S&P 500 over S&P 400 Midcap

Outperformance Note

GBP quanto


S&P 500 over S&P 400 Midcap after 5 year

term


of.

Jan-02 Oct-04 Jul-07 Apr-10 Jan-13

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MID Index Local Currency 5Y Perfor-mance - S&P 500 Index Local Currency

Performance Spread

S&P 400 Mid cap Index outperforms S&P in this historical backtest

Summary

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Forwards are very important – The benefit of locking in current forward levels is seen

in the large headline rate of FTSE 100 over S&P 500

Correlation and Volatility of each underlying combine to give the spread volatility

Allocation tailored to differing prospects between two indices (region-region, sector-

sector, etc.)

Gain increased exposure to performance of one index over another, with defined

downside

Summary

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Summary of sensitivities (generalised)

Delta: Positive the “out-performer”, negative the “under-performer”

Long volatility on the Outperformance Options, with the Knock-in, day 1 sensitivity

~neutral

Short correlation

The long vol exposure is likely to be dominant over the short correlation exposure.

Disclaimer

This is a marketing communication and has not been prepared in accordance with legal requirements designed to promote independence of investment research and

is not subject to any prohibition of dealing ahead of the dissemination of investment research.

The information in this document is derived from sources believed to be reliable but which have not been independently verified. Any prices included within this

communication are for indicative purposes only. Catley Lakeman Securities makes no guarantee of its accuracy and completeness and is not responsible for errors of

transmission of factual or analytical data, nor is it liable for damages arising out of any person’s reliance upon this information. All charts and graphs are from publicly

available sources or proprietary data. The opinions in this document constitute the present judgment of Catley Lakeman Securities, which is subject to change without

notice.

This document is neither an offer to sell, purchase or subscribe for any investment nor a solicitation of such an offer. This document is intended for the use of

institutional and professional customers and is not intended for the use of private customers. This document is not intended for distribution in the United States of

America or to US persons. This document is intended to be distributed in its entirety. No consideration has been given to the particular investment objectives, financial

situation or particular needs of any recipient.

Catley Lakeman Securities is regulated by the Financial Conduct Authority. Firm FSA Reference No. 484826. Catley Lakeman Securities is the trading name of

Catley Lakeman LLP. Registered Office: One Eleven Edmund Street, Birmingham. B3 2HJ. Registration Number: OC336585

DISCLAIMER

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outperformance options catley lakeman winter offsite – january 2014

Documents

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correlation correlation

implied volatility

differing volatility

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increasing volatility

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