Delta Hedging.

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The principal investors in most convertible securities are hedge funds that engage in convertible arbitrage strategies. These investors typically purchase the convertible and simultaneously sell short a certain number of the issuer’s common shares that underlie the convertible. The number of shares they sell short as a percent of the shares underlying the convertible is approximately equal to the risk-neutral probability at that point in time (as determined by a convertible pricing model that uses binomial option pricing as its foundation) that the investor will eventually convert the security into common shares. This probability is then applied to the number of common shares the convertible security could convert into to determine the number of shares the hedge fund investor should sell short (the “hedge ratio”).

As an example, assume a company’s share price is $10 at the time of its convertible issuance. A hedge fund purchases a portion of the convertible, which gives the right to convert into 100 common shares of the issuer. If the hedge ratio is 65%, the hedge fund may sell short 65 shares of the issuer’s stock on the same date as the convertible purchase. During the life span of the convertible, the hedge fund investor may sell more shares short or buy shares, based on the changing hedge ratio. To illustrate, if one month after purchasing the convertible (and establishing a 65-share short position) the issuer’s share price decreases to $9, the hedge ratio may drop from 65 to 60%. To align the hedge ratio with the shares sold short as a percent of shares the investor has the right to convert the security into, the hedge fund investor will need to buy five shares in the open market from other shareholders and deliver those shares to the parties who had lent the shares originally. “Covering” five shares of their short position leaves the hedge fund with a new short position of 60 shares. If the issuer’s share price two months after issuance increases to $11, the hedge ratio may increase to 70%. In this case, the hedge fund investor may want to be short 70 shares. The investor achieves this position by borrowing 10 more shares and selling them short, which increases the short position from 60 to 70 shares. This process of buying low and selling high continues until the convertible either converts or matures.

The end result is that the hedge fund investor is generating trading profits throughout the life of the convertible by buying stock to reduce the short position when the issuer’s share price drops, and borrowing and selling shares short when the issuer’s share price increases. This dynamic trading process is called “delta hedging,” which is a well-known and consistently practiced strategy by hedge funds. Since hedge funds typically purchase between 60% and 80% of most convertible securities in the public markets, a significant amount of trading in the issuer’s stock takes place throughout the life of a convertible security. The purpose of all this trading in the convertible issuer’s common stock is to hedge share price risk embedded in the convertible and create trading profits that offset the opportunity cost of purchasing a convertible that has a coupon that is substantially lower than a straight bond from the same issuer with the same maturity.

In order for hedge funds to invest in convertible securities, there needs to be a substantial amount of the issuer’s common shares available for hedge funds to borrow, and adequate liquidity in the issuer’s stock for hedge funds to buy and sell shares in relation to their delta hedging activity. If there are insufficient shares available to be borrowed or inadequate trading volume in the issuer’s stock, a prospective issuer is generally discouraged from issuing a convertible security in the public markets, or is required to issue a smaller convertible, because hedge funds may not be able to participate. Alternatively, an issuer could attempt to privately place a convertible with a single non-hedge fund investor. However, it may be impossible to find such an investor, and even if found, the required pricing for the convertible is likely to be disadvantageous for the issuer.

When a new convertible security is priced in the public capital markets, it is generally the case that the terms of the security imply a theoretical value of between 102% and 105% of face value, based on a convertible pricing model. The convertible is usually sold at a price of 100% to investors, and is therefore underpriced compared to its theoretical value. This practice provides an incentive for hedge funds to purchase the security, knowing that, by delta hedging their investment, they should be able to extract trading profits at least equal to the difference between the theoretical value and “par” (100%). For a public market convertible with atypical characteristics (e.g., an oversized issuance relative to market capitalization, an issuer with limited stock trading volume, or an issuer with limited stock borrow availability), hedge fund investors normally require an even higher theoretical value (relative to par) as an inducement to invest.

Convertible pricing models incorporate binomial trees to determine the theoretical value of convertible securities. These models consider the following factors that influence the theoretical value: current common stock price; anticipated volatility of the common stock return during the life of the convertible security; risk-free interest rate; the company’s stock borrow cost and common stock dividend yield; the company’s credit risk; maturity of the convertible security; and the convertible security’s coupon or dividend rate and payment frequency, conversion premium, and length of call protection.

Synthetic Structured Financial Instruments. Note Quote.

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An option is common form of a derivative. It’s a contract, or a provision of a contract, that gives one party (the option holder) the right, but not the obligation to perform a specified transaction with another party (the option issuer or option writer) according to specified terms. Options can be embedded into many kinds of contracts. For example, a corporation might issue a bond with an option that will allow the company to buy the bonds back in ten years at a set price. Standalone options trade on exchanges or Over The Counter (OTC). They are linked to a variety of underlying assets. Most exchange-traded options have stocks as their underlying asset but OTC-traded options have a huge variety of underlying assets (bonds, currencies, commodities, swaps, or baskets of assets). There are two main types of options: calls and puts:

  • Call options provide the holder the right (but not the obligation) to purchase an underlying asset at a specified price (the strike price), for a certain period of time. If the stock fails to meet the strike price before the expiration date, the option expires and becomes worthless. Investors buy calls when they think the share price of the underlying security will rise or sell a call if they think it will fall. Selling an option is also referred to as ”writing” an option.
  • Put options give the holder the right to sell an underlying asset at a specified price (the strike price). The seller (or writer) of the put option is obligated to buy the stock at the strike price. Put options can be exercised at any time before the option expires. Investors buy puts if they think the share price of the underlying stock will fall, or sell one if they think it will rise. Put buyers – those who hold a “long” – put are either speculative buyers looking for leverage or “insurance” buyers who want to protect their long positions in a stock for the period of time covered by the option. Put sellers hold a “short” expecting the market to move upward (or at least stay stable) A worst-case scenario for a put seller is a downward market turn. The maximum profit is limited to the put premium received and is achieved when the price of the underlyer is at or above the option’s strike price at expiration. The maximum loss is unlimited for an uncovered put writer.

Coupon is the annual interest rate paid on a bond, expressed as percentage of the face value.

Coupon rate or nominal yield = annual payments ÷ face value of the bond

Current yield = annual payments ÷ market value of the bond

The reason for these terms to be briefed here through their definitions from investopedia lies in the fact that these happen to be pillars of synthetic financial instruments, to which we now take a detour.

According to the International Financial Reporting Standards (IFRS), a synthetic instrument is a financial product designed, acquired, and held to emulate the characteristics of another instrument. For example, such is the case of a floating-rate long-term debt combined with an interest rate swap. This involves

  • Receiving floating payments
  • Making fixed payments, thereby synthesizing a fixed-rate long-term debt

Another example of a synthetic is the output of an option strategy followed by dealers who are selling synthetic futures for a commodity that they hold by using a combination of put and call options. By simultaneously buying a put option in a given commodity, say, gold, and selling the corresponding call option, a trader can construct a position analogous to a short sale in the commodity’s futures market.

Because the synthetic short sale seeks to take advantage of price disparities between call and put options, it tends to be more profitable when call premiums are greater than comparable put premiums. For example, the holder of a synthetic short future will profit if gold prices decrease and incur losses if gold prices increase.

By analogy, a long position in a given commodity’s call option combined with a short sale of the same commodity’s futures creates price protection that is similar to that gained through purchasing put options. A synthetic put seeks to capitalize on disparities between call and put premiums.

Basically, synthetic products are covered options and certificates characterized by identical or similar profit and loss structures when compared with traditional financial instruments, such as equities or bonds. Basket certificates in equities are based on a specific number of selected stocks.

A covered option involves the purchase of an underlying asset, such as equity, bond, currency, or other commodity, and the writing of a call option on that same asset. The writer is paid a premium, which limits his or her loss in the event of a fall in the market value of the underlying. However, his or her potential return from any increase in the asset’s market value is conditioned by gains limited by the option’s strike price.

The concept underpinning synthetic covered options is that of duplicating traditional covered options, which can be achieved by both purchase of the underlying asset and writing of the call option. The purchase price of such a product is that of the underlying, less the premium received for the sale of the call option.

Moreover, synthetic covered options do not contain a hedge against losses in market value of the underlying. A hedge might be emulated by writing a call option or by calculating the return from the sale of a call option into the product price. The option premium, however, tends to limit possible losses in the market value of the underlying.

Alternatively, a synthetic financial instrument is done through a certificate that accords a right, based on either a number of underlyings or on having a value derived from several indicators. This presents a sense of diversification over a range of risk factors. The main types are

  • Index certificates
  • Region certificates
  • Basket certificates

By being based on an official index, index certificates reflect a given market’s behavior. Region certificates are derived from a number of indexes or companies from a given region, usually involving developing countries. Basket certificates are derived from a selection of companies active in a certain industry sector.

An investment in index, region, or basket certificates fundamentally involves the same level of potential loss as a direct investment in the corresponding assets themselves. Their relative advantage is diversification within a given specified range; but risk is not eliminated. Moreover, certificates also carry credit risk associated to the issuer.

Also available in the market are compound financial instruments, a frequently encountered form being that of a debt product with an embedded conversion option. An example of a compound financial instrument is a bond that is convertible into ordinary shares of the issuer. As an accounting standard, the IFRS requires the issuer of such a financial instrument to present separately on the balance sheet the

  • Equity component
  • Liability component

On initial recognition, the fair value of the liability component is the present value of the contractually determined stream of future cash flows, discounted at the rate of interest applied at that time by the market to substantially similar cash flows. These should be characterized by practically the same terms, albeit without a conversion option. The fair value of the option comprises its

  • Time value
  • Intrinsic value (if any)

The IFRS requires that on conversion of a convertible instrument at maturity, the reporting company derecognizes the liability component and recognizes it as equity. Embedded derivatives are an interesting issue inasmuch as some contracts that themselves are not financial instruments may have financial instruments embedded in them. This is the case of a contract to purchase a commodity at a fixed price for delivery at a future date.

Contracts of this type have embedded in them a derivative that is indexed to the price of the commodity, which is essentially a derivative feature within a contract that is not a financial derivative. International Accounting Standard 39 (IAS 39) of the IFRS requires that under certain conditions an embedded derivative is separated from its host contract and treated as a derivative instrument. For instance, the IFRS specifies that each of the individual derivative instruments that together constitute a synthetic financial product represents a contractual right or obligation with its own terms and conditions. Under this perspective,

  • Each is exposed to risks that may differ from the risks to which other financial products are exposed.
  • Each may be transferred or settled separately.

Therefore, when one financial product in a synthetic instrument is an asset and another is a liability, these two do not offset each other. Consequently, they should be presented on an entity’s balance sheet on a net basis, unless they meet specific criteria outlined by the aforementioned accounting standards.

Like synthetics, structured financial products are derivatives. Many are custom-designed bonds, some of which (over the years) have presented a number of problems to their buyers and holders. This is particularly true for those investors who are not so versatile in modern complex instruments and their further-out impact.

Typically, instead of receiving a fixed coupon or principal, a person or company holding a structured note will receive an amount adjusted according to a fairly sophisticated formula. Structured instruments lack transparency; the market, however, seems to like them, the proof being that the amount of money invested in structured notes continues to increase. One of many examples of structured products is the principal exchange-rate-linked security (PERLS). These derivative instruments target changes in currency rates. They are disguised to look like bonds, by structuring them as if they were debt instruments, making it feasible for investors who are not permitted to play in currencies to place bets on the direction of exchange rates.

For instance, instead of just repaying principal, a PERLS may multiply such principal by the change in the value of the dollar against the euro; or twice the change in the value of the dollar against the Swiss franc or the British pound. The fact that this repayment is linked to the foreign exchange rate of different currencies sees to it that the investor might be receiving a lot more than an interest rate on the principal alone – but also a lot less, all the way to capital attrition. (Even capital protection notes involve capital attrition since, in certain cases, no interest is paid over their, say, five-year life cycle.)

Structured note trading is a concept that has been subject to several interpretations, depending on the time frame within which the product has been brought to the market. Many traders tend to distinguish between three different generations of structured notes. The elder, or first generation, usually consists of structured instruments based on just one index, including

  • Bull market vehicles, such as inverse floaters and cap floaters
  • Bear market instruments, which are characteristically more leveraged, an example being the superfloaters

Bear market products became popular in 1993 and 1994. A typical superfloater might pay twice the London Interbank Offered Rate (LIBOR) minus 7 percent for two years. At currently prevailing rates, this means that the superfloater has a small coupon at the beginning that improves only if the LIBOR rises. Theoretically, a coupon that is below current market levels until the LIBOR goes higher is much harder to sell than a big coupon that gets bigger every time rates drop. Still, bear plays find customers.

Second-generation structured notes are different types of exotic options; or, more precisely, they are yet more exotic than superfloaters, which are exotic enough in themselves. There exist serious risks embedded in these instruments, as such risks have never been fully appreciated. Second-generation examples are

  • Range notes, with embedded binary or digital options
  • Quanto notes, which allow investors to take a bet on, say, sterling London Interbank Offered Rates, but get paid in dollar.

There are different versions of such instruments, like you-choose range notes for a bear market. Every quarter the investor has to choose the “range,” a job that requires considerable market knowledge and skill. For instance, if the range width is set to 100 basis points, the investor has to determine at the start of the period the high and low limits within that range, which is far from being a straight job.

Surprisingly enough, there are investors who like this because sometimes they are given an option to change their mind; and they also figure their risk period is really only one quarter. In this, they are badly mistaken. In reality even for banks you-choose notes are much more difficult to hedge than regular range notes because, as very few people appreciate, the hedges are both

  • Dynamic
  • Imperfect

There are as well third-generation notes offering investors exposure to commodity or equity prices in a cross-category sense. Such notes usually appeal to a different class than fixed-income investors. For instance, third-generation notes are sometimes purchased by fund managers who are in the fixed-income market but want to diversify their exposure. In spite of the fact that the increasing sophistication and lack of transparency of structured financial instruments sees to it that they are too often misunderstood, and they are highly risky, a horde of equity-linked and commodity-linked notes are being structured and sold to investors. Examples are LIBOR floaters designed so that the coupon is “LIBOR plus”:

The pros say that flexibly structured options can be useful to sophisticated investors seeking to manage particular portfolio and trading risks. However, as a result of exposure being assumed, and also because of the likelihood that there is no secondary market, transactions in flexibly structured options are not suitable for investors who are not

  • In a position to understand the behavior of their intrinsic value
  • Financially able to bear the risks embedded in them when worst comes to worst

It is the price of novelty, customization, and flexibility offered by synthetic and structured financial instruments that can be expressed in one four-letter word: risk. Risk taking is welcome when we know how to manage our exposure, but it can be a disaster when we don’t – hence, the wisdom of learning ahead of investing the challenges posed by derivatives and how to be in charge of risk control.

Credit Default Swaps.

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Credit default swaps are the most liquid instruments in the credit derivatives markets, accounting for nearly half of the total outstanding notional worldwide, and up to 85% of total outstanding notional of contracts with reference to emerging market issuers. In a CDS, the protection buyer pays a premium to the protection seller in exchange for a contingent payment in case a credit event involving a reference security occurs during the contract period.

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The premium (default swap spread) reflects the credit risk of the bond issuer, and is usually quoted as a spread over a reference rate such as LIBOR or the swap rate, to be paid either up front, quarterly, or semiannually. The contingent payment can be settled either by physical delivery of the reference security or an equivalent asset, or in cash. With physical settlement, the protection buyer delivers the reference security (or equivalent one) to the protection seller and receives the par amount. With cash settlement, the protection buyer receives a payment equal to the difference between par and the recovery value of the reference security, the latter determined from a dealer poll or from price quote services. Contracts are typically subject to physical settlement. This allows protection sellers to benefit from any rebound in prices caused by the rush to purchase deliverable bonds by protection buyers after the realization of the credit event.

In mature markets, trading is highly concentrated on 5 year contracts, and to certain extent, market participants consider these contracts a ‘‘commodity.’’ Usual contract maturities are 1, 2, 5, and 10 years. The coexistence of markets for default swaps and bonds raises the issue on whether prices in the former merely mirrors market expectations already reflected in bond prices. If credit risk were the only factor affecting the CDS spread, with credit risk characterized by the probability of default and the expected loss given default, the CDS spread and the bond spread should be approximately similar, as a portfolio of a default swap contract and a defaultable bond is essentially a risk-free asset.

However, market frictions and some embedded options in the CDS contract, such as the cheapest-to-deliver option, cause CDS spreads and bond spreads to diverge. The difference between these two spreads is referred to as the default swap basis. The default swap basis is positive when the CDS spread trades at a premium relative to the bond spread, and negative when the CDS spread trades at a discount.

Several factors contribute to the widening of the basis, either by widening the CDS spread or tightening the bond spread. Factors that tend to widen the CDS spread include: (1) the cheapest-to-deliver option, since protection sellers must charge a higher premium to account for the possibility of being delivered a less valuable asset in physically settled contracts; (2) the issuance of new bonds and/or loans, as increased hedging by market makers in the bond market pushes up the price of protection, and the number of potential cheapest-to-deliver assets increases; (3) the ability to short default swaps rather than bonds when the bond issuer’s credit quality deteriorates, leading to increased protection buying in the market; and (4) bond prices trading less than par, since the protection seller is guaranteeing the recovery of the par amount rather than the lower current bond price.

Factors that tend to tighten bond spreads include: (1) bond clauses allowing the coupon to step up if the issue is downgraded, as they provide additional benefits to the bondholder not enjoyed by the protection buyer and (2) the zero-lower bound for default swap premiums causes the basis to be positive when bond issuers can trade below the LIBOR curve, as is often the case for higher rated issues.

Similarly, factors that contribute to the tightening of the basis include: (1) existence of greater counterparty risk to the protection buyer than to the protection seller, so buyers are compensated by paying less than the bond spread; (2) the removal of funding risk for the protection seller, as selling protection is equivalent to funding the asset at LIBOR. Less risk demands less compensation and hence, a tightening in the basis; and (3) the increased supply of structured products such as CDS-backed collateralized debt obligations (CDOs), as they increase the supply of protection in the market.

Movements in the basis depend also on whether the market is mainly dominated by high cost investors or low cost investors. A long credit position, i.e., holding the credit risk, can be obtained either by selling protection or by financing the purchase of the risky asset. The CDS remains a viable alternative if its premium does not exceed the difference between the asset yield and the funding cost. The higher the funding cost, the lower the premium and hence, the tighter the basis. Thus, when the market share of low cost investors is relatively high and the average funding costs are below LIBOR, the basis tends to widen. Finally, relative liquidity also plays a role in determining whether the basis narrows or widens, as investors need to be compensated by wider spreads in the less liquid market. Hence, if the CDS market is more liquid than the corresponding underlying bond market (cash market), the basis will narrow and vice versa.