Equity derivative

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The term equity derivative describes a class of financial instruments whose value is at least partly derived from one or more underlying equity securities. Market participants trade equity derivatives in order to transfer or transform certain risks associated the underlying. Options are by far the most common equity derivative, however there are many other types of equity derivatives that are actively traded.

Equity options

See the option article for a more complete description of options.

Equity options are the most common type of equity derivative. They provide the right, but not the obligation to trade a quantity of stock at a set price at a future time.

Warrants

See warrants for the complete article.

A warrant is similiar in many respects to an equity option, with the exception that they are issued by private parties, typically the corporation on which the warrant is based, rather than a public options exchange. A warrant will often confer the same rights as an equity option and can even be traded in secondary markets. However, warrants are considered over the counter instruments, and thus are usually only traded by financial institutions with the capacity to settle and clear these types of transactions.

Warrants are often issued as part of a bond issue. They can be used to enhance the yield of the bond, and make them more attractive to potential buyers. Warrants can also be used in private equity deals. For instance, it was a common practice during the height of the dot-com bubble for a landlord of sought-after commercial real-estate to demand warrants from high-tech startups as part of the lease agreement.

Characteristics of Warrants

Warrants have similar characteristics to that of other equity derivatives, such as options, for instance:

• Exercising: A warrant is exercised when shares are bought through the warrant.

The warrant parameters, such as exercise price, are fixed shortly after the issue of the bond. With warrants, it is important to consider the following main characteristics:

• Premium: A warrants 'premium' represents how much extra you have to pay for your shares, when buying them through the warrant, as compared to buying them in the regular way.
• Gearing (leverage): A warrants 'gearing' is the way to ascertain how much more exposure you have to the underlying shares using the warrant, as compared to the exposure you would have if you buy shares through the market.
• Expiration Date: This is the date the warrant expires. If you plan on exercising the warrant you must do so before the expiration date. The more time remaining until expiry, the more time for the underlying security to appreciate, which, in turn, will increase the price of the warrant. Therefore, the expiry date is the date on which the right to exercise no longer exists.

Warrants are longer-dated options and are generally traded over-the-counter.

The Pricing of Warrants

There are various methods (models) of evaluation available to theoretically value warrants, including the Black-Scholes evaluation model. However, it is important to have some understanding of the various influences on warrant prices. The market value of a warrant can be divided into two components:

• Intrinsic value: This is simply the difference between the exercise (strike) price and the underlying stock price. Warrants are also referred to as at-the-money or out-of-the-money, depending on where the current asset price is in relation to the warrant's exercise price. Thus, for instance, for call warrants, if the stock price is below the strike price, the warrant has no intrinsic value (only time value - to be explained shortly). If the stock price is above the strike, the warrant has intrinsic value and is said to be in-the-money.
• Time value: Time value can be considered as the value of the continuing exposure to the movement in the underlying security that the warrant provides. Time value declines as the expiry of the warrant gets closer. This erosion of time value is called time decay. It is not constant, but increases rapidly towards expiry. A warrant's time value is affected by the following factors:
  • Time to expiry: The longer the time to expiry, the greater the time value of the warrant. This is because the price of the underlying asset has a greater probability of moving in-the-money which makes the warrant more valuable.
  • Volatility: The more volatile the underlying instrument, the higher the price of the warrant will be (as the warrant is more likely to end up in-the-money).
  • Dividends: To include the factor of receiving dividends depends on if the holder of the warrant is permitted to receive dividends from the underlying asset.
  • Interest rates: An increase in interest rates will lead to more expensive call warrants and cheaper put warrants. The level of interest rates reflects the opportunity cost of capital - as this is an introductory level course, we shall not go into this at great length.

Different Types of Warrants

A wide range of warrants and warrant types are available. The reasons you might invest in one type of warrant may be different from the reasons you might invest in another type of warrant.

• Equity Warrants: Equity warrants can be call and put warrants.
  • Call warrants give you the right to buy the underlying securities
  • Put warrants give you the right to sell the underlying securities
• Covered Warrants: A covered warrant is, basically, a warrant issued in a foreign currency. They can prove to be a flexible tool.
• Basket Warrants: As with a regular equity index, warrants can be classified at, for example, an industry level. Thus, it mirrors the performance of the industry.
• Index Warrants: Index warrants use an index as the underlying asset. Your risk is dispersed - using index call and index put warrants - just like with regular equity indexes. It should be noted that they are priced using index points.

That is, you deal with cash, not directly with shares.

Benefits of Trading Warrants

• Portfolio protection: Put warrants allow you to protect the value of your portfolio against falls in the market or in particular shares.
• Low cost
• Leverage

Risks of Trading Warrants

There are certain risks involved in trading warrants – including time decay. Time Decay: 'Time value' diminishes as time goes by - the rate of decay increases the closer you reach the date of expiration.

Convertible Bonds

Convertible bonds are a combination of bonds and equity. Convertible bonds are bonds with a maturity date and coupon, with a call option where the holder has the right to convert into equity.

A convertible bond has several desirable qualities for the investor or trader. Some of them include the following:

• They provide ‘asset protection’. The value of the convertible bond will only fall to the value of the ‘bond floor’.
• Convertible bonds can provide the possibility of ‘high equity returns’.
• Convertible bonds are usually of a less volatile nature than ‘regular’ shares.

In other words:Convertible bonds offers the following main advantages for the trader or investor:

• Asset protection of the bond, combined with the possibility of equity returns.

Convertible bonds offer the following main advantage for the issuer of the CB:

• Debt at a relatively low cost.

Convertible Bond Terminology - Valuation Parameters

There are variations to the regular structure of convertible bonds. However, there is a basic structure that needs to be understood, which include the following elements:

• Convertible price: Price per share at which conversion takes place
• Parity (Conversion) value: Equity price × Conversion ratio
• Conversion premium: Represent the divergence of the market value of the CB compared to that of the parity value
• Issue size
• Issue date
• Maturity
• Nominal value
• Coupon
• Conversion price: The price per share at which conversion takes place.
• Conversion ratio
• Call protection

Behaviour of Convertible Bonds

The 4 main stages of convertible bond behaviour are:

• In-the-money convertible bonds
• At-the-money convertible bonds
• Out-the-money
• Junk convertible bonds

The behaviour of convertible bonds

In-the-money:  Conversion Price is < Equity Price. At-the-money:  Conversion Price is = Equity Price. Out-the-money: Conversion Price is > Equity Price. 

• In-the-money CB's are considered as being within Area of Equity (the right hand side of the diagram)
• At-the-money CB's are considered as being within Area of Equity & Debt (the middle part of the diagram)
• Out-the-money CB's are considered as being within Area of Debt (the lefthand side of the diagram)

It is important to point out that the Japanese and American markets are of primary global importance. For markets other than the USA and Japan, the following usually apply:

• Markets are often illiquid
• Pricing is frequently non-standardised

These two domestic markets are the largest in terms of market capitalisation.

• Japan: In Japan, the convertible bond market is relatively more regulated than other markets. It consists of a large number of small issuers.
• USA: It is a highly liquid market compared to other domestic markets. Domestic investors have tended to be most active within US convertibles
• Europe: Convertible bonds have become an increasingly important source of finance for firms in Europe. Compared to other global markets, European convertible bonds tend to be of high credit quality.

Asia (ex Japan): The Asia region provides a wide range of choice for an investor. Each domestic market within the Asian convertible bond market is at a various level of development.

Forwards, Futures & Other Equity Derivatives

Futures are legally binding contracts which set the price of something today, but where delivery takes place at a specific time in the future. Futures are used primarily for speculation and hedging. Futures have a contract specification which cannot be varied.

Futures are always:

• Guaranteed by a clearing house
• Margined (in order to reduce/eliminate counterparty credit risk)
• Traded in the public domain - by open outcry or screen

Forward Contracts & Futures Contracts

Forwards and futures contracts are rather simple financial tools. Futures contracts are very similar to forward contracts

The price of a forward contract is partly determined by the following:

• Current underlying asset price
• Interest rates

Forward and futures contracts are almost identical except for: Forward contracts are traded over-the-counter (i.e. OTC) where contracts are made between two parties, where there is no centralised exchange based trading, i.e., contracts are not standardised.

Stock Index Futures

Stock index futures are used for hedging, trading, investmentsHedging using stock index futures could involve hedging against, for instance:

• A portfolio of shares
• Equity index options

Trading using stock index futures could involve, for instance:

• Volatility trading (The greater the volatility the greater the likelihood of profit taking – usually taking relatively small but regular profits)

Investing via the use of stock index futures could involve:

• Exposure to a market or sector without having to actually purchase shares directly

Please note the following cases of equity hedging with index futures:

• Where your portfolio ‘exactly’ reflects the index (this is unlikely). Here, your portfolio is perfectly hedged via the index future.
• Where your portfolio does not entirely reflect the index (this is more likely to be the case). Here, the degree of correlation between the underlying asset and the hedge is not high. So, your portfolio is unlikely to be ‘fully hedged’.

Equity index futures and options tend to be in liquid markets for close to delivery contracts. They trade for cash delivery, usually based on a multiple of the underlying index on which they are defined (for example £10 per index point).

OTC products are usually for longer maturities, and are usually a form of options product. For example, the right but not the obligation to cash delivery based on the difference between the designated strike price, and the value of the designated index at the expiration date. These are traded in the wholesale market, but are often used as the basis of guaranteed equity products, which offer retail buyers a participation if the equity index rises over time, but which provides guaranteed return of capital if the index falls. Sometimes these products can take the form of exotic options (for example Asian options or Quanto options).

Forward prices of equity indices are calculated by computing the cost of carry of holding a long position in the consitutuent parts of the index. This will typically be

• The risk-free interest rate, since the cost of investing in the equity market is the loss of interest
• Minus the imputed dividend yield on the index, since an equity investor receives the sum of the dividends on the component stocks. Since these occur at different times, and are difficult to predict, estimation of the forward price is something of an art, particularly if there are not many stocks in the chosen index.

Indices for futures are the well-established ones, such as S&P, FTSE, DAX, CAC40 and other G12 country indices. Indices for OTC products are broadly similar, but offer more flexibility.

Equity basket derivatives

These are options, futures or swaps where the underlying is a non-index basket of shares. They have similar characteristics to equity index derivatives, but are always traded OTC, as the basket definition is not standardised in the way that an equity index is.

Single-Stock Futures

Single-stock futures are exchange-traded futures contracts based on an individual underlying security rather than a stock index. Their performance is similar to that of the underlying equity itself, although as futures contracts they are usually traded with greater leverage. Another difference is that holders of long postions in single stock futures typically do not receive dividends and holders of short positions do not pay dividends. Single-stock futures may be cash-settled or physically settled by the transfer of the underlying stocks at expiration, although in the United States only physical settlement is used.

Swaps

Swaps are agreements to exchange a stream of future payments. The structure of such payments are pre-determined from the outset. A swap is agreed between two parties, where both parties (buyer and seller) are obliged to the contract.

The most common type of swap is the interest rate swap. The interest rate swap is an agreement to exchange fixed-rate payments against floating-rate payments

• The fixed-rate payer pays a fixed rate to the fixed-rate receiver.
• The fixed-rate receiver pays a floating rate.

The floating rate is normally an interest rate based on a rate such as LIBOR.

Equity Index Swaps

An equity index swap is an agreement between two parties to swap

• Two sets of cash flows
• On predetermined dates
• For an agreed number of years

The cash flows will be:

• An equity index value
• Swapped, for instance, with LIBOR

Swaps can be considered as being a relatively straight forward way of gaining exposure to an asset class you require. They can also be relatively cost efficient. As this is introductory level material further details of swaps can be found in intermediate/advanced courses.

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