The World of Equity Derivatives

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The World of Equity Derivatives The World of Equity Derivatives

The Essential Toolbox for Investors

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DEEP LIQUIDITY • Reliable, discreet and bespoke broking service • Expert sourcing of liquidity in equity derivatives • Technology leveraged with the human touch

Equity Derivatives Dealing: London: +44 (0)20 7894 8880 Paris: +33 1 55 80 11 75 Zurich: +41 43 456 8764 Copenhagen: +45 33 30 08 10

Equity Derivatives

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Contents

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The World of Equity Derivatives

46 52 82 38 Forewords 10 By Robert C Merton, John and Natty McArthur University Professor, Harvard Business School 13 Developing the world of equity derivatives Peter Reitz, member of the Eurex Executive Board 18 Equity derivatives – forging ahead Natasha de Terán, editor, The World of Equity Derivatives

30 Modern times Natasha de Terán

64 Deriving extra value from dividends Byron Baldwin, Eurex

Products

69 On the right track – exchange traded funds derivatives Paolo Giulianini and Enrico Camerini, UniCredit

38 Exploiting equity index derivatives Pamela Finelli and Mehdi Alighanbari, Deutsche Bank 46 Singling out the future Ricardo Dias de Sousa, Altura Markets

74 Eurex – working with the over-the-counter markets Natasha de Terán

52 Options on the rise Aaron Brask, Barclays Capital

79 Exploiting cash and futures markets Frédéric Ponzo, NET2S, Charles Annandale, XBZ and Sarfraz Thind

58 Reaping reward from sector futures Sophie Billiard and Cyrille Drouot, Société Générale

82 Common equity derivatives trading techniques made easy with Bloomberg Carole Bernard, Bloomberg

History 24 The early days Natasha de Terán

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107 113 133 139 86 Pricing structured products with Eurex Dr Ralf Seiz, University of St Gallen 91 Surveying the future Natasha de Terán Case studies 96 From pure protection to real asymmetric profiles Dr René Sieber, Dynagest 100 Implementing statistical arbitrage pairs trading with single stock futures Dr Rainer Tafelmayer, Allianz Global Investors

110 Volatility – the perfect asset class for the equity fund manager Byron Baldwin and Alexey Weizmann, Eurex

128 Tailoring solutions with derivatives in a global asset management firm Mark den Hollander and Derick le Roux, Fortis Investments

113 Sector strategies Pamela Finelli and Mathew Howe, Deutsche Bank

133 Delivering absolute returns Raimund Saxinger, Frankfurt-Trust Asset Management

118 Gaining credit exposure through equity options – balancing portfolios Dr Harald Henke and Helmut Paulus, Union PanAgora Asset Management

136 Exploiting dividends Paolo Giulianini, Unicredit

104 Equity options and cash markets Lars Nackter and Rajdeep Patgiri, Merrill Lynch

122 Index dispersion and correlation trading Serge Darolles, Eric Talleux and Emmanuelle Jay, SGAM

107 Extracting value from volatility Eric Hermitte and Gilbert Keskin, Crédit Agricole Asset Management Group

126 Equity derivatives in pension funds Poul Thybo, APK Pensionskasse AG, and Natasha de Terán

139 Investing in Russia with equity derivatives Douglass Welch, Troika Dialog

142 Index of advertisers

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Editor Eurex Editorial Adviser Group Editorial Director Managing Editor Editorial Assistant Sub-Editor

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Natasha de Terán Byron Baldwin Claire Manuel Suzy Robinson Lauren Rose-Smith Nick Gordon

Group Art Director Art Editors

David Cooper Nicky Macro James White Zac Casey Tim Richards

Designer Group Production Director

Group Sales Director Andrew Howard Sales Executives Tony Norton, Neil McPhee Client Relations Director Natalie Spencer Group Commercial Director Deputy Chief Executive Publisher and Chief Executive

The World of Equity Derivatives The Essential Toolbox for Investors

Mark Payne Hugh Robinson Alan Spence

Published by Newsdesk Communications Ltd 5th Floor, 130 City Road, London, EC1V 2NW, UK T +44 (0) 20 7650 1600 F +44 (0) 20 7650 1609 www.newsdeskmedia.com Newsdesk Communications Ltd publishes a wide range of business and customer publications. For further information please contact Natalie Spencer, Client Relations Director, or Alan Spence, Chief Executive.

Newsdesk Communications Ltd is a Newsdesk Media Group company.

On behalf of: Eurex Frankfurt AG Neue Börsenstraße 1, 60487 Frankfurt/Main, Germany www.eurexchange.com International Securities Exchange LLC 60 Broad Street, New York, NY 10004, USA www.ise.com Pictures: Alamy, photolibrary, Corbis, Reuters, Getty Repro: ITM Publishing Services Printed by Buxton Press ISBN: 1-905435-82-7 Your contacts at Eurex Eurex Frankfurt AG Peter Noha T +49 69 211 1 47 17 Peter.Noha@eurexchange.com Eurex Zürich AG Markus-Alexander Flesch T +41 58 854 29 48 Markus-Alexander.Flesch@eurexchange.com London Office Byron Baldwin T +44 20 78 62 72 32 Byron.Baldwin@eurexchange.com Paris Office Nicolas Kageneck T +33 1 5 52 76 7 76 Nicolas.Kageneck@eurexchange.com New York Office Rachna N. Mathur T +1 212 918 48 28 Rachna.Mathur@eurexchange.com Chicago Office Lothar Kloster T +1 312 544 10 57 Lothar.Kloster@eurexchange.com Your contact at ISE Jeanine Hightower, Director, Business Development T +1 212 897 0357 jhightower@ise.com

© 2008. The entire contents of this publication are protected by copyright. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means: electronic, mechanical, photocopying, recording or otherwise, without the prior permission of the publisher. The views and opinions expressed by independent authors and contributors in this publication are provided in the writer’s personal capacities and are their sole responsibility. Their publication does not imply that they represent the views or opinions of Eurex Frankfurt AG or Newsdesk Communications Ltd and must neither be regarded as constituting advice on any matter whatsoever, nor be interpreted as such. The reproduction of advertisements in this publication does not in any way imply endorsement by Eurex Frankfurt AG or Newsdesk Communications Ltd of products or services referred to therein. This publication is published for information purposes only and does not constitute investment advice, respectively it does not constitute an offer, solicitation or recommendation to acquire or dispose of any investment or to engage in any other transaction.

Eurex derivatives (other than Dow Jones EURO STOXX 50® Index Futures contracts, Dow Jones EURO STOXX® Select Dividend 30 Index Futures contracts, Dow Jones STOXX 50® Index Futures contracts, Dow Jones STOXX® 600 Index Futures contracts, Dow Jones STOXX® Large/Mid/Small 200 Index Futures contracts, Dow Jones EURO STOXX® Banks Futures contracts, Dow Jones STOXX® 600 Banks/Industrial Goods & Services/Insurance/Media/Personal & Household Goods/Travel & Leisure/Utilities Futures contracts, Dow Jones Global Titans 50 IndexSM Futures contracts, DAX® Futures contracts, MDAX® Futures contracts, TecDAX® Futures contracts, SMIM® Futures contracts, SLI Swiss Leader Index® Futures contracts, Eurex inflation derivatives, and Eurex interest rate derivatives) are currently not available for offer, sale or trading in the United States or by United States persons.

Buxl®, DAX®, DivDAX®, eb.rexx®, Eurex®, Eurex Bonds®, Eurex Repo®, Euro GC Pooling®, Eurex Strategy WizardSM, EXTF®, FDAX®, FWB®, MDAX®, ODAX®, TecDAX®, VDAX®, VDAX-NEW®, Xetra® and XTF Exchange Traded Funds® are registered trademarks of DBAG. The service mark MSCI Russia is the exclusive property of Morgan Stanley Capital International, Inc. RDXxt® is a registered trademark of Wiener Börse AG (Vienna Stock Exchange). iTraxx® is a registered trademark of International Index Company Limited (IIC) and has been licensed for the use by Eurex. IIC does not approve, endorse or recommend Eurex or iTraxx® Europe 5-year Index Futures, iTraxx® Europe HiVol 5-year Index Futures and iTraxx® Europe Crossover 5-year Index Futures. Eurex is solely responsible for the creation of the Eurex iTraxx® Credit Futures contracts, their trading and market surveillance. ISDA® neither sponsors nor endorses the product’s use. ISDA® is a registered trademark of the International Swaps and Derivatives Association, Inc. SLI®, SMI®, SMIM®, SPI® and VSMI® are registered trademarks of SWX Swiss Exchange.

STOXX®, Dow Jones STOXX® 600 Index, Dow Jones STOXX® Large 200 Index, Dow Jones STOXX® Mid 200 Index, Dow Jones STOXX® Small 200 Index, Dow Jones STOXX® TMI Index, VSTOXX® Index, Dow Jones EURO STOXX 50® DVP, Dow Jones EURO STOXX® Select Dividend 30 Index, Dow Jones EURO STOXX®/STOXX® 600 Sector Indexes as well as the Dow Jones EURO STOXX 50® Index and Dow Jones STOXX 50® Index are service marks of STOXX Ltd. and/or Dow Jones & Company, Inc. Dow Jones, Dow Jones Global Titans 50 IndexSM and Dow Jones Sector Titans IndexesSM are service marks of Dow Jones & Company, Inc. The derivatives based on these indexes are not sponsored, endorsed, sold or promoted by STOXX Ltd. or Dow Jones & Company, Inc., and neither party makes any representation regarding the advisability of trading or of investing in such products. The names of other companies and third party products may be trademarks or service marks of their respective owners. The ISE logo is a registered trademark of International Securities Exchange, LLC.

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Foreword

By Robert C Merton, John and Natty McArthur University Professor, Harvard Business School

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well-functioning financial system, including its legal and accounting components, is a key driver for realising the long-term growth and development potential of an economy. This conclusion emerges from a variety of studies, including cross-country comparisons, firm-level studies, time-series research and econometric investigations that use panel techniques. A number of economic historians have concluded that those regions – be they cities, states or countries – that developed relatively more sophisticated and well-functioning financial systems were the ones that were also the subsequent leaders in economic development of their times.

New financial product and market designs, improved computer and telecommunications technology and advances in the science of finance during the past 35 years have led to dramatic and rapid global changes in the structure of the financial system. The scientific breakthroughs in finance during this period both shaped and were shaped by the extraordinary flow of financial innovation, which coincided with those changes. The cumulative impact has significantly affected all of us – as users, producers or overseers of the financial system.

Finance science has informed practice across a wide spectrum, with powerful prescriptions for portfolio allocation, asset

pricing, performance measurement, risk management and corporate financial decision-making. But surely the prime exemplifying case is the development, refinement and broad-based adoption of derivative securities such as futures, options, swaps and other contractual agreements. It is estimated that more than USD 500 trillion – half a quadrillion – of derivatives are outstanding today globally (in notional terms).

Practitioner innovations in these financialcontracting technologies have improved efficiency by expanding opportunities for risk sharing, lowering transaction costs and reducing information and agency costs.

It was my great good fortune to be involved at the outset of this extraordinary period of development in finance science and the financial system. In 1973, when the late Fischer Black, Myron Scholes and I published the research on option pricing named by me ‘the Black-Scholes model’ – which was recognised a quarter century later in Stockholm – options and derivative securities generally were seen as an arcane and specialised area of finance.

The modern financial derivatives markets were then in their infancy. The Chicago Board Options Exchange, the first options exchange, had just been launched; the first financial futures contracts were trading in the Midwest; and the first interest-rate swap contract was still eight years away into the future. Neither Eurex nor the International Securities Exchange (ISE) was yet in existence.

At the time there was surely scepticism about

the market’s potential and considerable doubt over whether the instruments then being developed would prove beneficial.

The methodology for valuing derivatives we had developed not only enabled listed, over-the-counter and executive stock options to be priced, but it also gave us insights into solving a wide range of other structurally equivalent valuation problems, such as a unified theory for pricing corporate liabilities; mortgage prepayment options; offshore oil drilling rights; real-estate and movie right options; loan guarantees; deposit insurance; farm price supports; drug discovery phasing; shelf-space in supermarkets; modularity in production and multiple-fuel power plants; indeed even tenure contracts for professors.

A whole world of possibilities had opened up.

Although we recognised in the early days that the approach we had developed had wide-ranging application, we could not have forecast the extraordinary speed, breadth and magnitude of the subsequent adoption and development of the derivative markets.

In addition to improving the means to price options, our analysis provided a means of measuring their risk exposure. The methodology also filled a need – with the creation of an options exchange, the pace and scale of trading were such that options traders and market makers could no longer operate based on simple heuristics and guesswork. The ‘theory’ enabled options traders to take much bigger positions because they could use the model to figure out how to hedge their exposures; they could

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be much more efficient and they could control their risk much better.

It was an enormous kick to see how this highly mathematical and abstract theory was put to mainstream practical use – and it has been extraordinarily gratifying to watch its usage extend and the financial derivatives markets develop. Computational and telecommunications technology has been an equally important catalyst for the markets’ development. It powers the financial markets, providing access to traders and trading interests around the globe. It has democratised, improved, enhanced and empowered the financial marketplace. It has reduced costs dramatically, enhanced competition, increased transparency and driven a multitude of efficiencies.

This technology has also helped fuel the development of new kinds of trading mechanics, such as the algorithmic trading strategies deployed on the electronic marketplaces. It has supported product development, given birth to a new type of trader and has allowed once esoteric complex products to become liquidly traded assets.

The revolutionising effect of technology is clearly evidenced in the emergence of new financial marketplaces, such as the then Deutsche Terminbörse (the DTB, now Eurex) and ISE, whose histories are outlined in detail in this book.

The impact of those two pioneering electronic marketplaces cannot be underestimated; since the DTB erupted onto the European scene in 1990 and ISE stormed into the archaic trading pits just under a decade later, trading costs have plummeted and derivatives trading volumes have escalated dramatically.

The major advantages of using derivatives are that they are efficient in transferring huge amounts of risk; they can be customised, they are reversible and they are non-invasive. The instruments serve as a form of sophisticated ‘adapters’, linking nation-state financial systems together and helping to bring about a unified world economy. They have also brought about vast reductions in costs and have opened up multiple channels of financial flows.

Modern financial technology permits the separation of risk exposure selection and management from physical investment choices, capital expenditure plans, ownership

and governance of assets. Risk exposures can be radically changed without affecting capital, trade or income flows or the balance sheet. Thus, risk is now a separate dimension of management decisions.

Financial innovation creates enormous opportunities to improve risk sharing, lower transactions costs and reduce information and agency costs with significant gains, especially for smaller and developing countries. However, this same innovation creates daunting challenges.

As we all know, in the past, there have been financial incidents, and even crises, that cause some to raise questions about innovations and the soundness of the financial science theories used to engineer them. With the ongoing major liquidity and credit crisis that has hit financial markets

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require increased reliance on computer models and with that, a need for increased managerial attention to the reliability of those models along with a more seamless interface between computer-model generated recommendations and human judgement – all of which implies a growing place for financial-engineering expertise as part of the general manager’s knowledge base. The successful financial-service providers and governmental overseers in the impending future must learn to fully exploit the functional benefits of innovation in financial technology while managing the dysfunctional aspects of that innovation.

Addressing this knowledge gap offers considerable challenge to private institutions and government. The arrival of this volume, which patiently lays out the principles and

It was an enormous kick to see how this highly mathematical and abstract theory was put to mainstream practical use and institutions particularly in the US, UK and continental Europe, these questions are again being raised. We are still in the process of addressing the immediate impact of this crisis and in gathering the necessary data to properly analyse what happened.

Whatever those findings, global financial innovation will continue. As we look to the future, we must not ignore that cumulative innovation leads to major changes in the basic institutional hierarchy and in the infrastructure to support it. And, as a consequence of innovation, the knowledge base needed to manage and oversee financial institutions effectively can change considerably from the traditional training and experience of many managers in financial institutions and government regulators.

That knowledge gap may widen since the worldwide adoption of financial innovation is anticipated to accelerate in the impending future. Growing complexity of products and the need for more rapid decision-making will

definitions of derivative securities and the practical market structure to support them, could not have been better timed. Whether novice student or seasoned professional, the reader is in for a treat. Enjoy!

Robert C Merton is currently the John and Natty McArthur University Professor at the Harvard Business School. After receiving a PhD in economics from Massachusetts Institute of Technology in 1970, he served on the finance faculty of MIT’s Sloan School of Management until 1988, when he moved to Harvard. Professor Merton is past President of the American Finance Association, a member of the National Academy of Sciences and a Fellow of the American Academy of Arts and Sciences. In 1993, he received the inaugural Financial Engineer of the Year Award from the International Association of Financial Engineers. Professor Merton was awarded the Alfred Nobel Memorial Prize in Economic Sciences in 1997.

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Interesting times ahead in equity derivatives With the credit crisis affecting financial markets as a whole, equity markets have experienced a significant increase in correlation over the past nine months, resulting in exotic equity derivative portfolios realising large losses.

However this increase in correlation is not limited to equity assets values alone: correlation has also increased between asset volatilities as well as cross-spot volatility correlations – giving rise to ‘Super-Gamma Scenarios’.

Alex Langnau, Global Head of Quantitative Analytics, at Dresdner Kleinwort assesses how this impacts the valuation of exotic portfolios.

he most obvious proof of the credit crisis is the CDO market where spreads of super-senior tranches have sky-rocketed more than 20-fold since August 2007 – implying credit (base) correlations of close to one1.

T

However market distress has by no means been restricted to credit markets. It is widely understood that the market has seen equity derivative portfolio losses as well. Again, these losses are largely attributable to an increase in correlation: while some of these losses are mark-to-market and could potentially be recovered as markets revert to normal, a significant proportion are trading losses resulting from cross-gamma bleeding.

It is remarkable that not only the correlations between equity assets have been much higher than expected, high correlations

Figure 1: 18-month volatility skew of a (quanto) basket of SPX, SX5E, N225 The high correlation scenario assumes 100% correlation between volatilities and -80% correlation between all volatilities and spots. This steepening of the basket skew relative to the zero correlation case will be referred to as correlation skew in this article.

1.5 year basket volatility skew in a low and high correlation environment

Source: Dresdner Kleinwort

between volatilities themselves as well as large negative correlations between spots and volatilities of different assets have created ‘Super Short Gamma’ positions ‘conspiring’ against trading desks2.

It is well known that negative correlation between spot and volatility gives rise to volatility skew that can be hedged by vanilla (risk-reversal) positions. Super-gamma scenarios are more exotic in nature and imply cross-effects (such as the volatility of Asset 2 increasing when Spot 1 decreases). While moves of this type will not affect vanilla options, the pricing of 'cross-vanna' sensitive products are impacted.

Figure 1 shows how super-gamma scenarios leave their ‘footprint’ by steepening the volatility skew of basket options. This could ultimately provide a hedging framework for super-gamma scenarios.

Figure 2: Correlation exposure as a function of the basket level The graph shows how this correlation exposure across spot could in principle be hedged by trading basket options at different strikes.

The residual exposure is given in blue.

Correlation hedge across different levels of spot for a typical structured product

Source: Dresdner Kleinwort

Dresdner Bank AG Lon

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Powerful thinking in structured equity derivatives In order to demonstrate this point, Figure 2 shows the correlation sensitivity of a typical structured product, based on a basket of SPX, STOXX50E, N225 incorporating ‘worst-of’ and callability option features. What makes this trade especially toxic is that the correlation exposure becomes more extreme as the market goes down. This phenomenon is particularly unwelcome as correlations are likely to increase when the market drops significantly.

Figure 2 shows correlation exposure can, in principle, be hedged across different levels of spot using basket options.

Even if the hedge portfolio is not liquid enough to be traded across all strikes at present, the construction of ‘quasi-static’ hedges of this type can play a useful role in the estimation of pricing contributions attributable to correlation skew.

They can also help to validate more complex models that exhibit these features.

From a mathematical perspective, the tuning of correlation between volatilities as well as cross-asset spot-volatility correlations in essence ‘dials’ different choices of copulas.

These combine individual (market implied) distributions into joined multi-asset distributions, thereby giving rise to the different basket skews of Figure 1.

It is important to note that the observation of the basket skew by itself does not suffice to fully describe the dependencies between assets. Consider a ‘chewing-gum’ move where one asset depreciates 20% while another increases by an amount such that the overall level of the basket remains unchanged.

Whereas such idiosyncratic events would not alter the basket skew, options on the ‘worst-of’ will be significantly affected. In a basket of N components where N is large, the impact of idiosyncratic events on the basket level itself is suppressed by 1/N whereas such events can play a dominant role in determining the worst/best performer no matter how large N is. Putting it the other way, the observation of basket volatility skews can only provide limited information about the distributions of worst/best-of products.

Light up new possibilities In a fast-moving market, you can’t rely on what’s been done well before. You need a partner who will deliver the best solution for what you need right now.

Dresdner Kleinwort offers equity derivative innovation across the product spectrum – from vanilla options to complex structured solutions. We cover all major trading hubs, including a fast-growing presence in developing markets. Plus in every transaction, we aim to combine competitive www.dresdnerkleinwort.com/EQD

Unexpected viewpoints.

Radical thinking.

Inspiration.

However the observation of the two together could provide powerful clues about appropriate choices of copulas in the equity derivatives market.

An extreme example is the iTraxx 12%-22% CDO 5-year tranche spread which went from 3bps to 110 bps between June 2007 and March 2008.

2 The situation has become even worse in practice as even interest rates and foreign exchange moves have increased short gamma trading profiles.

1

Dresdner Kleinwort is the investment banking division of Dresdner Bank AG and a member of the Allianz Group. In the US we undertake business as Dresdner Kleinwort Securities LLC, a registered broker dealer and member of the Financial Industry Regulatory Authority (FINRA). Dresdner Bank AG London Branch, 30 Gresham Street, London EC2V 7PG. Authorised by the German Federal Financial Supervisory Authority and by the Financial Services Authority; regulated by the Financial Services Authority for the conduct of UK business and incorporated in Germany as a stock corporation with limited liability.

Registered in England and Wales No FC007638.

resdner Bank AG London Branch, 30 Gresham Street, London EC2V 7PG. Member of the Allianz Group. Authorised by the German Federal Financial Supervisory Authority and by the Financial Services Authority in the UK.

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Foreword

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Developing the world of equity derivatives

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By Peter Reitz Member of the Eurex Executive Board

n the fourth Friday in January 1990, approximately 12,000 equity derivatives contracts were traded on the Deutsche Terminbörse (DTB) – all of them options on German equities. On the same day in 2008, more than 10 million equity derivatives contracts were traded on Eurex, DTB’s successor. These included futures and options contracts linked to equity indexes and exchange traded funds; to sector and to volatility derivatives; and to equity options and single stock futures on Austrian, Belgian, Dutch, French, Italian, German, Russian, Scandinavian, Spanish, Swiss and US equities. In addition, Eurex now lists contracts on emerging market indexes and on dividends.

Eurex is the only exchange globally to offer such a wide range of equity derivatives products.

The International Securities Exchange (ISE) – which is now part of the Eurex Group, debuted only eight years ago – has meanwhile become the world’s largest equity options trading venue.

However, this volume is not solely about Eurex and the ISE. It is about equity derivatives generally – and its publication is timely. Firstly, this is because equity derivatives volumes are growing strongly. In the six months to 31 June, 2008, Eurex equity derivatives volumes climbed by 40.2 percent year-on-year to 300.7 million contracts. In our strongest segment – equity index derivatives – a total of 469.4 million contracts were traded, up 32.2 percent year-on-year to the end of June 2008.

Dow Jones STOXX® Sector Futures posted a 27.8 percent year-on-year growth.

Turnover in the most heavily traded product on Eurex – the future on the Dow Jones EURO STOXX 50® Index – grew by 30.1 percent to 194.9 million contracts, while turnover in options contracts on the Dow Jones EURO STOXX 50® Index totalled 180.7 million contracts – a 52.8 percent increase year-on-year.

Secondly, it is because the market is getting broader. By way of example, the breadth of Eurex’s equity derivatives product offering is widening substantially.

Over the past year alone, we have added to our suite of sector products; introduced the world’s first exchange traded contract that focuses solely on the dividend element of a widely used and traded equity index, the

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Foreword

Dow Jones EURO STOXX 50® Index; and we have introduced futures and options on the MSCI Russia Index.

Finally, it is because the equity derivatives markets are likely to grow even further, thanks to three factors: the widening of clearance capabilities, geographical expansion and technology.

Eurex is currently focusing on these three core areas and we believe they are key to the future of equity derivatives markets: we are enhancing and expanding our over-the-counter (OTC) clearing offering through Eurex Clearing, extending our geographical reach and enhancing our technology.

Eurex has long offered wholesale trading facilities to the OTC markets and already has

the largest OTC offering of any exchange or clearing house globally. Through Eurex Clearing, users can now clear fixed income and capital markets derivatives, equity and equity index derivatives, as well as derivatives on CO2, inflation, exchange traded funds, credit, volatility indexes and equity index dividends.

The new functions include a Multilateral Trade Registration facility (which is explored further on pages 74 to 77). The reduction in trading costs afforded under our new programme has seen fees fall by as much as 75 percent for equity options and up to 83 percent for single stock futures, making our OTC facility very competitive, globally. Initiatives such as these have made it even more attractive for users

OTC trading volumes at Eurex

Eurex OTC trading facilities – a snapshot 2008 year to date (to June 2008) Total volume: 458,935,022 Total index futures volume: 35.50m Total index options volume: 176.87m Total single stock futures volume: 108.08m Total single stock options volume: 83.51m Total fixed income futures volume: 30.83m Total fixed income options volume: 27.15m

May 2008 - record month Total volume: 99,383,966 Total index futures volume: 2.66m Total index options volume: 27.49m Total single stock futures volume: 47.52m Total single stock options volume: 14.66m Total fixed income futures volume: 3.36m Total fixed income options volume: 3.39m

to submit their bilateral OTC transactions to Eurex Clearing.

At Eurex we have also been expanding our geographical reach. This is evident in our purchase of the International Securities Exchange and our planned implementation of a transatlantic trading and clearing link; in the ongoing introduction of a wider geographical range of underlyings; and in the establishment of telecommunications hubs in markets such as Dubai, where we were the first exchange to set up such a hub.

Finally, we have been making substantial improvements to our platform through the Eurex Technology Roadmap.

We have further improved our data distribution functionalities, lowered the latency of our trading system significantly and have introduced advanced risk management tools. In April this year, we rolled out a new optional interface, which has reduced average round-trip times of futures orders to 5 milliseconds. The minimum latency time achieved by the Eurex® system for single order transactions – when using our Proximity Services – is now as low as around 1 millisecond, and already as much as 30 percent of the daily order volume for benchmark products, such as the Dow Jones EURO STOXX 50® Index Futures and DAX® Futures, is entered via the new interface.

The Technology Roadmap is not only a response to current trends in electronic derivatives trading – and particularly electronic equity derivatives trading – it also promotes them. New trading strategies such as algorithmic trading and new products have led to a considerable increase in daily transaction volumes, resulting in a greater demand for more order book depth and additional market information.

Our next milestone is the planned implementation of the Real-time Risk Management function in the final quarter of 2008, which will allow participants to obtain a permanent evaluation of their risks throughout the trading day.

We look forward to continuing working with you on these and other developments and, as ever, we welcome your input and ideas. We hope to continue to remain at the forefront of this innovative and important marketplace and thank you for your support.

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When derivatives get complex Expertise is critical Liquidity is vital Paris-London-Frankfurt OTCex Group is a global broker offering intermediary services and analysis on equity derivatives, money and interest-rate markets.

For more detailed information please visit www.otcexgroup.com. Š2008 OTCex Group All rights reserved.

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YOUR ARCHIT Swiss World Architecture: MFO Park in Zurich by Burckhardt+Partner and Raderschall

Photo by Jakob AG, Trubschachen

Recent Amendments of Swiss Disclosure Rules relating to Derivatives Prompted by a number of recent cases, where raiders have secretly built up significant stakes in Swiss listed companies and then suddenly confronted both the target and the remaining shareholders with a dominating minority stake, the Swiss Federal Banking Commission (“SFBC�) and the Swiss Legislator amended and tightened the applicable disclosure rules in several steps. Such new rules aim in particular also at certain derivative structures used by raiders to avoid early disclosure of their plans.

Former legislation Until last year, anyone building up a stake in a company with its registered office in Switzerland listed on a Swiss stock exchange, had to publicly disclose the holding of more than 5% , in such listed company s shares or options. Further reporting requirements were triggered when the stake exceeded or fell below the threshold percentages 10, 20, 33 1/3, 50 or 66 2/3 of the voting rights. In particular, the fact that in the past the acquisition or sale of call options and/or the writing of put options on less than 5% of the voting rights was exempt from the reporting obligations regardless of the percentage of the preexisting shareholding of the party entering into the transaction was heavily criticized. As a result, a potential acquirer could

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E C T S I N L E G A L M AT T E R S combine the acquisition of 4,99% of the shares of the target with the acquisition of call options on also 4,99% of the shares of the target without having to report such holdings. Further the fact that only the acquisition or sale of call options providing for physical settlement and the writing of put options providing for physical settlement needed to be reported, was used by acquirers to have financial intermediaries build up significant stakes in target companies with a view to acquire such stakes at a later stage.

New legislation and new implementing regulations In a concerted effort of the Federal Parliament and the SFBC to close certain loopholes that allowed raiders to sneak up on several Swiss companies in the past, both the Stock Exchange Act and its implementing regulations were changed.

On the one hand, the lowest percentage threshold triggering a reporting requirement was decreased from 5% to 3% and additional thresholds (15%, 25%) were implemented. Further amendments include the consequences of a violation of the reporting requirements and the inclusion of so called indirect acquisitions. The latter include other types of transactions or agreements, in particular option, swap or similar transactions, which a person enters with the view to subsequently launch a tender offer, even if such transaction or agreement does not provide for a firm entitlement to request the sale of the shares.

On the other hand, the SFBC implemented as per July 1, 2007 and as per December 1, 2007 several amendments to the implementing ordinance which among other things in particular deleted the former exemption for cash-settled options in its entirety and further requires the aggregation of all acquired positions in the underlying and any derivates and thus eliminated the possibility to acquire 4,99% of the shares of the target and at the same time of up to 4,99% in long options without having to disclose such stake.

Further, the amendment also introduced a reporting obligation for the acquisition and sale of put options or other rights to sell the underlying and the writing of call options (or the granting of other rights to acquire the underlying) which had been exempt so far from the obligation to disclose.

Due to these changes – in particular the exemption for cashsettled derivatives – also cash-settled swaps with or without any embedded physical options or forwards relating to the underlying will have to be disclosed, if the notional amount, i.e. the notional number of shares exceeds – together with any other direct or indirect positions held and together with any derivative positions held – any threshold percentage. According to the new rules, a netting of positions, e.g. call options and put options on the same underlying, is not allowed.

Therefore, in view of the new rules, banks and securities dealer should be wary of clients with a potential intent to obtain control

of a target company by means of derivative transactions in order to avoid the risk of being considered as a party acting in concert with the client and thus be joint and severally liable for potential fines, if the client does not fulfil its reporting obligations or, in the worst case, to be obliged to participate in a tender offer for the target company at a minimum price which will have to take into consideration – as the Swiss Takeover Board decided in a recent case – also the value of any options, other derivatives or similar rights obtained or granted by the acquirer.

Our team of experts is known as one of the largest dedicated and most specialized derivatives and structured finance teams in the Swiss marked. The practise team draws on the specialist skills and , technical expertise of lawyers from the firm s Corporate Finance and Banking Department, the Tax Department and the Capital Markets Group.

We are renowned for our expertise in complex and challenging transactions and pride ourselves for being innovative and , commercially aware of our clients needs. The pooling of these diverse skills in a practical manner and the structure of our practise team enable our specialists to provide our clients, the , world s leading financial institutions and companies, with a responsive, consistent and focused service for issues relating to derivative or structured finance transactions.

Our derivatives and structured finance team advises Swiss and foreign financial institutions, corporates and special purpose vehicles entering into ISDA master agreements, securities lending and repo transactions and collateral arrangements relating to derivatives transactions. We advise in relation to Swiss corporates entering into OTC swap transactions as well as acting for special purpose vehicles entering into credit derivative trades as part of complex structured finance transactions.

Our specific expertise includes advising on OTC derivatives, listed derivatives, hedge funds, structured funds, investment vehicles, alternative investment structures and products as well as numerous other financial products. Our continuing cooperation with the leading national and international industry organisations further enables us to maintain and develop our leading position in the derivatives and structured finance markets.

If you would like to know more about the subjects areas mentioned above or our services, please contact: Dr. Christoph Heiz +41 (0)44 396 9191 Dr. Alexander Vogel +41 (0)41 768 1111 To email one of the above, please use firstname.lastname@ml-law.ch

Zurich: Forchstrasse 452, P.O. Box 1432, CH-8032 Zürich • Tel: +41 44 396 91 91 • Fax: +41 44 396 91 92 • zurich@ml-law.ch Zug: Grabenstrasse 25, CH-6340 Baar / Zug • Tel: +41 41 768 11 11 • Fax: +41 41 768 11 12 • zug@ml-law.ch Geneva: In association with Croisier Gillioz & Associés, 61, Rue du Rhône, P.O. Box 3127, CH-1211 Genève 3 • mail@cglaw.ch

www.meyerlustenberger.ch

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Introduction

Equity derivatives – forging ahead

By Natasha de Terán Editor, The World of Equity Derivatives

E

quity derivatives are in many ways the unsung heroes of the financial markets.

Dwarfed, in notional terms, by turnover in the fixed income and even in the credit markets, they are all-toooften sidelined by market commentators and observers.

But as any active financial market participant will know, equity derivatives instruments now constitute a critical part of the investment and trading process.

No right-minded investor would step in to make an equity allocation without at least first looking at the equity derivatives markets for direction. More sophisticated

investors will next consider equity derivatives as investment supplements – using them to hedge out, leverage or overlay their core portfolios. Others, further up the sophistication curve, will instead use them as proxies or alternatives to direct cash market equity investments.

Furthermore, the equity derivatives markets have given birth to many of the innovations that now pepper – and are even commonplace in – other parts of the financial marketplace. The structured product business, for instance, is an equity market innovation; credit protection portfolio insurance (CPPI) is another. So too are warrants and certificates, as well as the dispersion and correlation strategies that are now widely deployed in credit and other markets.

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Introduction

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We will undoubtedly witness the market’s continued growth and equity derivative product innovation It is instruments and innovations such as these that will have helped investors weather or even profit from the storms of the last 12 to 16 months.

No markets have escaped unscathed from the turmoil that began to unfold in a small corner of the US mortgage markets in the middle of 2007. However, savvier equity investors have been able to protect themselves from some of the resulting asset price falls, while others will have immunised themselves by investing in structured products, or even by adopting sophisticated market-neutral strategies.

The equity derivatives products now tradable in the over-the-counter and listed markets, such as Eurex, are core to all of these investment processes. Without them we would all be much worse off.

Two of the key attractions of equity derivatives that are all too often forgotten, are these: the underlying assests are liquidly traded and both the derivative instruments and the cash underlyings have readily observable, independently verifiable prices. These two elements should now be at the forefront of investors’ minds when considering where and how to make asset allocations. They should thus serve to stimulate the usage of equity derivatives, making these instruments an increasingly integral part of the investment process.

Will the equity derivatives market ever match or surpass the fixed income or credit derivatives markets in sheer size? If one had to hazard a guess, one would probably say not, but in sheer inventiveness it is unlikely to be surpassed. As a

result, we will undoubtedly witness the market’s continued growth and equity derivative product innovation. We will almost certainly also see fresh applications introduced for existing equity derivatives instruments and strategies.

This book will hopefully provide some useful market history and information on the products and strategies and serve as useful background to the developments that undoubtedly lie ahead. We hope you will enjoy it.

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Equity derivatives – Taking chances for new business growth Industry developments in capital markets

by Susanne Kloess, managing director of Accenture’s Capital Markets industry practice and Adriana Scozzafava, partner in Accenture’s Exchanges and Clearing & Settlement practice Since their introduction in the world of capital markets, equity derivatives have played an increasingly important role. Used initially mainly to hedge risk, one could say that equity derivatives have now become a quite common form of financial instrument in the global capital markets.

Even so, we are witnessing some interesting developments around this class of financial instruments, as they offer different types of market participants an interesting chance to grow their business – even in the rough times we are currently facing. Some thoughts: Standardized equity derivatives such as exchange traded options have seen a massive rise in volume in recent years with the number of contracts traded on the most important exchanges tripling

between 2002 and 2007. Notwithstanding, we think that the growth of this market on a worldwide basis is not finished yet. Besides examples like buy side players currently shifting money from structured credit markets to equity derivatives markets, these products present an opportunity for market infrastructure players, especially mid-sized and smaller stock exchanges, to capitalize on a new revenue stream.

Why is that? The – long and often predicted – consolidation in the fragmented market infrastructure landscape has finally started globally. We have recently seen transatlantic M&A’s as well as alliances and investment of Western players with and in Asian stock exchanges. On the one hand, these

Traded contracts (Equity Options) from 2002 to 2007

Average Monthly OTCED Trades

Source: ISDA 2007 OTC Derivatives Survey, Accenture Analysis. Trades represent the average monthly volume of non-vanilla equity derivative trades that primary market makers attempted to settle (2007, 2008 are projected); percentage shown in line on graph is the indicative ratio of breaks to trades over a cumulative three-year period, depicted as 12 monthly increments and two yearly totals.

developments are attributable to macroeconomic change - the emergence of a world with multiple centers of economic power and activity, compared to the world we once knew, which was dominated by only three economic centers (US, Europe and Japan). On the other hand, this process has been accelerated by the fact that most exchanges have become listed entities themselves today, thus acquiring the means to invest in new markets as part of their growth story and - at the same time – shareholder value becoming a priority for them.

While the big industry players continue to expand their geographic reach as mentioned above or try, for example, to attract new listings, smaller and medium-sized players in the world of exchanges continue to remain focused on their local markets – with enormous and steadily increasing competitive pressure from big international players as well as smaller national exchanges, who have carved out a regional niche and/or enjoy strong political backing.

For these mid-sized players, the launch of new equity derivatives markets with standardized and easy to capture products might be an option to create new revenue streams and higher-margin growth with existing and new customers who are looking for more advanced or sophisticated products. Obviously, this is easier said than done.

An established ‘stable’ equities market with adequate levels of depth and liquidity is a prerequisite for launching an equity derivatives market that can be expected to achieve reasonable success. Since comprehensive market knowledge is essential for selling such products, local players stand to benefit significantly. In addition, launching a new equity derivatives market requires changes in the regulatory environment, e.g. defining the clearing framework and accompanying rules, i.e. guarantees and requisites for membership. However, this represents as well a starting point for the adoption of global/best practices by domestic markets/exchanges in terms of transparency.

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Advertisement feature

This is, by the way, not only true for Europe but also for many Asian markets that register similar equity volumes as developed markets, but still trade lower volumes in equity derivatives, indicating there is more room for growth.

of the operations’ organization, the redesign of processes and the use of emerging technologies (e.g. integrating gateways). Firms that invest early in such trade process transformations might have a strategic advantage for profits across the value chain.

On the other hand, the structured equity derivatives, issued by sell side institutions and traded mostly in OTC (OTCED), have evolved slower then standard exchange based products and certainly more gradually than their structured credit cousins. The equity derivatives notional market grew modestly from 2003 to 2006 at approximately 10%; however, from 2006 to 2007 it expanded by 44% to approximately 6.4 trillion USD in notional value.

Selected players with a high interest in offering OTCED to their clients might even consider going further towards an outsourcing of trading infrastructure and settlement for those products to reduce fixed infrastructure costs and thus focus themselves on the more variable and potentially more profitable issuance and product structuring.

Structured equity derivatives have helped market participants to find additional revenues as they reaped a substantial benefit from customizing contract terms to meet their individual or their client’s needs. In our opinion the OTC equity derivatives market is unlikely to reach the size that we have seen with the credit derivatives market, however it can become a stable and attractive high margin, revenue stream for some players – regardless of their size. Even so, there exist challenges faced in issuance, including the complex process of designing and structuring these products to valuation and risk management. The following are two examples on how to mitigate such ‘side-effects’ around these products.

Exotic equity derivatives are not only hard to price and hard to attribute risk but are also difficult to process in a standard, straight-through manner (STP).

With the massive growth of the market, the ratio of breaks to trades has increased significantly. Along the trading value chain, we believe that there are three major impacts that a missing STP could have: capital lockup for potentially unsettleable trades, operational risks (e.g. lack of standards in processing protocols) and the inability to scale operations.

A recent Accenture report on operating models in investment banking showed that a major trend in realizing a truly strategic operating model is to establish capabilities that strive for execution excellence as a prerequisite to handling intensified globalization. One of the areas industry players are looking into is outsourcing – not only driven by cost cutting targets, but also to gain access to scarce but scalable resources. In these instances, outsourcing is of course not solely

For more information contact: Susanne Kloess, Accenture Maximilianstraße 35, D-80539 Munich, Germany E-mail: susanne.kloess@accenture.com or Adriana Scozzafava, Accenture

Gaining STP capabilities that thus help to build an OTCED business in a profitable way, very often requires a holistic transformation that encompasses the simplification

Torre Picasso, 28020 Madrid, Spain E-mail: adriana.scozzafava@accenture.com

limited to IT, but includes business and organizational processes.

A business process outsourcing of trading infrastructure and settlement for OTCED might be an option for mid-sized sell-side firms which cannot justify the business case for products that impose a high infrastructure cost and yet are forced to offer these to stay competitive. In doing so, such firms would be enabled to offer products to their clients that may not be as heavily traded as other products but are attractive to customers who want access to alternative revenue streams under tougher market conditions. Offloading the fixed cost of maintaining the infrastructure would allow mid-sized sell-side firms to reap the revenue benefit while also optimizing their cost base.

In conclusion, equity derivatives may offer opportunities for selected industry players to stay competitive in the ‘new’ capital markets as they appear after the credit crunch – and it is likely that we will see new business models evolve.

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History

The early days

Options trading can be traced far back in history. Natasha de Terรกn looks at the development of the equity options market in the United States.

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History

T

he Ancient Romans, Grecians and Phoenicians are understood to have used a form of options to insure against the costs of shipping. The instruments re-emerged in 17th-century Europe and one of the earliest written accounts can be found in John Houghton’s Collection for Improvement of Husbandry and Trade, a series of essays published in 1694 that looked at the then emergent equity options business in London.

Despite the fact that options seem to have their origins in Europe, it was across the Atlantic that they were to enter the financial mainstream. The modern options industry was born in 1973 in mid-America with the arrival of the first-ever dedicated options market: the Chicago Board Options Exchange (CBOE).

On 26 April, 1973, the CBOE’s first day of trading, 911 contracts were traded. Twenty years later, on 26 April, 2003, 1.3 million contracts were traded – and on the same day in 2008, 3.4 million contracts were traded on the exchange. To put that figure into a wider context, those 3.4 million contracts represented just a quarter of the US market’s total volume on that day; nearly 12 million options contracts were traded in the US on 25 April, 2008 (the nearest trading day), across seven exchanges.

The next three seminal events in the making of the options market as we know it today all occurred in 1975: the advent of computerised price reporting, the formation of The Options Clearing Corporation (OCC) and, most importantly, the adoption of the Black-Scholes model for pricing options.

But first, back to the birth of the CBOE. The CBOE The CBOE emerged in April 1973 from the belly of the Chicago Board of Trade (CBOT), which itself had been founded in 1848. In the late 1960s, trade in the CBOT’s family of soy bean, corn, grain and other agricultural commodities was on the wane, owing to

government guarantees which imposed floor prices, and production surpluses which prevented prices from rising too high.

In 1967, the CBOT hired Joseph W. Sullivan, a Wall Street Journal political correspondent. Sullivan was detailed to explore the feasibility of futures on other commodities that might stimulate a trading revival, while over at the rival Chicago Mercantile Exchange (CME) – then also an agricultural market – a young Leo Melamed1, was set to work on a similar brief.

By the end of the decade it had become apparent to both Melamed and Sullivan that a more radical departure was needed: financial instruments.

Here again the duo faced a problem; stock options and futures had been used before in the US, but the 1929 crash and subsequent depression had bred great hostility toward any form of ‘speculation’. Any derivatives that looked or sounded like wagers were treated with deep suspicion. Furthermore, in 1905 the Supreme Court had ruled that only futures that could be settled by physical delivery were legal – anything that could be settled only in cash constituted an illegal wager. This ruling presented an obstacle to their first idea – stock index futures based on the Dow Jones Index. Because there was no underlying asset that could be delivered, any such instruments would be outlawed.

While Melamed’s camp was to go on to develop currency futures, the CBOT’s Special Committee on Securities, led by Sullivan, instead started to focus on another instrument: options. The potential for options was decidedly brighter than that for index futures: the instruments would be legal, since the underlying asset – the stock

25

certificates referenced by the options – could be delivered. Just as significant, it seemed likely there would be demand for the product since a small over-the-counter (OTC) options market already existed in New York.

Four years after Sullivan’s Special Committee had been formed, a proposal was tabled: trading standardised stock options with fixed strike prices and durations on an organised exchange.

Regulatory obstacles But before this proposal could be transformed into reality, some considerable obstacles would have to be surmounted – not least of which was the supervisory one. To be able to proceed, they needed to secure approval from the US Securities Exchange Commission (SEC); and since the CBOT members were opposed to the idea of SEC supervision, it was decided in 1972 to incorporate the CBOE as an independent body with its own bylaws and governing board.

When CBOT officials started putting their ideas before the SEC they encountered immediate hostility. Sullivan is reported to have been told by a leading SEC offcial that he had “never seen a [market] manipulation” in which options were not involved. Another SEC official said there were “absolutely insurmountable obstacles” to the proposal, and that the CBOE “shouldn’t waste another nickel pursuing it.” He even compared options to “marijuana and thalidomide”.2 The exchange turned next to the external consultants, Robert R. Nathan Associates, who had previously researched the grain futures market for the US Department of Agriculture. It commissioned the firm to undertake a study on the public interest

More than 12 million options contracts were traded in the US on 25 April, 2008 across seven exchanges

Leo Melamed, now Chairman Emeritus of the Chicago Mercantile Exchange.

Sullivan interview quoted in Constructing a Market, Performing Theory: The Historical Sociology of a Financial Derivatives Exchange, by Donald MacKenzie of the University of Edinburgh and Yuval Millo of the London School of Economics, published in the American Journal of Sociology, July 2003.

1 2

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History

grounds for creating an options market. In turn, Nathan Associates turned to the Princeton University economists, Burton Malkiel and Richard Quand and their colleague William Baumol. Options, the trio were to argue, would “enrich the investor’s repertoire of strategies by allowing him to realise a different set of payoffs than he would have realised in their absence.”3 The Nathan report helped secure the CBOE an important ally in Milton Cohen, a former SEC official and a pre-eminent US securities lawyer. Cohen agreed to become special counsel to the CBOT and to lead its negotiations with the SEC. In a fortunate twist, Cohen was known to William Casey, who had been appointed to the chair of the SEC on Richard Nixon’s appointment as US president in 1971.

Ready for business Even with this piece of luck on its side, the CBOE’s launch would not take place until 26 April, 1973, when 200 members – a blend of “speculators, hopeless optimists, and dyed in-the-wool entrepreneurialists [sic]” met in the members' lounge of the CBOT and began buying and selling call options on 16 equities.4 Among the firms that traded on the first day was Goldman Sachs. At the CBOE's 25th anniversary celebration of the world's first listed options contracts, Robert Rubin – then

a banker at Goldman Sachs but later the US Secretary of the Treasury – recalled phoning Sullivan, by then CBOE’s founding president, to report that he was ready to trade.

Sullivan's response was: "What if nobody shows up?" "I said at least you've got an exchange," said Rubin. "We offered to do a trade. I said we would call Salomon Brothers, and we would do a trade between us. At least, you'll have one trade. We actually traded 911 contracts that day," said Rubin.5 Black-Scholes: a giant leap forward for the options business In October 1997, Professors Robert C Merton of Harvard University and Myron S Scholes of Stanford University were awarded the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel – otherwise known as the Nobel Prize.

The award was given for the development of a methodology which, in the words of the citation, had “paved the way for economic valuations in many areas…” and “… generated new types of financial instruments and facilitated more efficient risk management in society”.6 The importance of Black-Scholes was by no means unfamiliar to those operating in or close to financial circles, but by the time the prize was awarded, the model was so deeply ingrained in market practice, that many would have forgotten or simply

Prior to the development of the Black-Scholes Model, there was no standard method for pricing options and no means of ascribing a ‘fair value’ to them

ignored the long and arduous trajectory that had led to the development of the model. As the Nobel Award presenters said: “Attempts to value derivatives have a long history. As far back as 1900, the French mathematician Louis Bachelier reported one of the earliest attempts in his doctoral dissertation, although the formula he derived was flawed in several ways. Subsequent researchers handled the movements of stock prices and interest rates more successfully.

But all of these attempts suffered from the same fundamental shortcoming: risk premia were not dealt with in a correct way.”

History of the Black-Scholes Model Prior to the development of the BlackScholes Model, there was no standard method for pricing options and no means of ascribing a ‘fair value’ to them. The model effectively turned a guessing game into a mathematical science – a crucial leap, which enabled the derivatives markets to develop into the lucrative industry it is today.

At the time of the model’s development, Myron Scholes was professor of finance at Stanford University, while economist Robert Merton and mathematical physicist Fischer Black were both at Harvard.

The three Black-Scholes Model researchers – who were then still in their twenties – had set about trying to find an answer to derivatives’ pricing using mathematics. In so doing they were trying to solve an age-old problem that had dogged economists for centuries – how to counter the randomness of market forces.

The value of an option to buy or sell a share depends on the uncertain development of the share price to the date of maturity. It was therefore natural to suppose – as had earlier researchers – that valuing an option first required them to take a position on the risk premium. Black, Scholes and Merton showed that it was not in fact necessary to use any risk premium when valuing an option.

Black, Scholes and Merton’s arguments were at their core quite simple: if the price of a stock follows the standard model of a log-normal random walk in continuous time, and other simplifying assumptions are held, it should be possible to hedge any option transaction perfectly.

Nathan Associates 1969: Public Policy Aspects of a Futures-Type Market in Options on Securities.

Quoted from William B Crawford Jr, Maturing CBOE confident at 20 after growing pains, a resurgence in the Chicago Tribune, 26 April, 1993.

5 Quoted by Carol Bere in Exchange traded equity options come of age, Global Finance Magazine, 1 June, 1998.

6 Press release from the Royal Swedish Academy of Sciences, 14 October, 1997.

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The Black-Scholes formula Black and Scholes’ formula for a European call option can be written as: -rt

C = SN(d) - Le N (d – o √t ) where the variable d is defined by: 2 ln s + (r +o ) t 2 L d= o √t

According to this formula, the value of the call option C, is given by the difference between the expected share value (the first term on the right-hand side), and the expected cost (the second term) - if the option right is exercised at maturity. The formula says that the option value is higher the higher the share price today S, the higher the volatility of the share price (measured by its standard deviation) sigma, the higher the risk-free interest rate r, the longer the time to maturity t, the lower the strike price L, and the higher the probability that the option will be exercised (the probability is evaluated by the normal distribution function N).

The influence of Black-Scholes Although the authors had encountered earlier rejections, the Black-Scholes Model was first published in the 1973 article ’The Pricing of Options and Corporate Liabilities’7 and was later elaborated in ’Theory of Rational Option Pricing’ by Robert Merton.

Within six months of the publication, Texas Instruments had incorporated the Black-Scholes Model into their calculator.

Fellow economists quickly recognised the work as an important development. As well as solving a difficult technical problem, it showed how to approach a host of situations with ’option-like’ features.

It is difficult to overestimate the importance of the Model; it is used more widely today than ever and is a core component of the armoury of every options student and trader. In the words of option trader and theorist Nassim Taleb (who was not, in fact, a wholly uncritical admirer of the BlackScholes-Merton work): “Most everything

A prerequisite for efficient management of risk is that such instruments are correctly valued, or priced. A new method to determine the value of derivatives stands out among the foremost contributions to economic sciences over the last 25 years.

This year's laureates, Robert Merton and Myron Scholes, developed this method in close collaboration with Fischer Black, who died in his mid-fifties in 1995. These three scholars worked on the same problem: option valuation. In 1973, Black and Scholes published what has come to be known as the Black-Scholes formula. Thousands of traders and investors now use this formula every day to value stock options in markets throughout the world. Robert Merton devised another method to derive the formula that turned out to have very wide applicability; he also generalised the formula in many directions.

Black, Merton and Scholes thus laid the foundation for the rapid growth of markets for derivatives in the last ten years. Their method has more general applicability, however, and has created new areas of research – inside as well as outside of financial economics. A similar method may be used to value insurance contracts and guarantees, or the flexibility of physical investment projects.

Extract from Nobel Award Summation, 14 October, 1997.

that has been developed in modern finance since 1973 is but a footnote on the BSM [Black-Scholes-Merton] equation.”8 In 1987, Stephen Ross, then professor of economics and finance at Yale University, wrote: “… when judged by its ability to explain the empirical data, option-pricing theory is the most successful theory not only in finance, but in all of economics. It is now widely employed by the financial industry, and its impact on economics has been far ranging. At a theoretical level, we now understand that option-pricing theory is a manifestation of the force of arbitrage and that this is the same force that underlies much of neoclassical finance."

After Black-Scholes The theory was to prove a crucial breakthrough for the options market. The greatest benefit of being able to accurately price options, is, of course, the greater ability to hedge risk. But the most immediate benefit, from the CBOE’s point of view, was that it attracted more people to the options market.

Indeed, from the CBOE’s perspective the Model was transformative: it gave legitimacy to the notion of hedging and efficient derivatives pricing, and ultimately allowed the exchange to thrive.

The next pivotal moment in the option industry’s development arrived in 1975, when the SEC approved OCC as the central clearing corporation for exchange-listed options.

Two years earlier, when the CBOE first began trading options, clearing was

effected through the CBOE’s clearing subsidiary. But when the American Stock Exchange prepared to enter the stock options business the next year with its own options clearing house, member firms and the SEC urged AMEX and the CBOE to consider having a common clearing organisation.

In what was later described as a piece of “informal regulation on the part of the SEC”, the OCC was formed in 1975 as a common clearinghouse for all US equity options exchanges. As Paul G. Stevens, Jr., president and chief operating officer of OCC recalled: “It was strong jawboning on the part of the SEC and they were partnered by the member firm community, which strongly felt that they didn't need a proliferation of clearinghouses. The last thing the member firms wanted to see was three or more options clearing corporations. The SEC urged AMEX and CBOE to get together and, to their credit, they did and OCC was spun off from the CBOE as a jointlyowned entity of both the AMEX and the CBOE.”9 In 1975, AMEX and the Philadelphia Stock Exchange (PHLX) began listing equity options, followed by the Pacific Exchange (PCX) a year later.

Despite these new entrants, the CBOE stayed ahead of the pack. In 1980, it absorbed the options business of the Midwest Stock Exchange and in 1997 it bought out the New York Stock Exchange’s options business.

Authored by Fischer Black and Myron Scholes and published in the Journal of Political Economy.

Nassim Taleb, ‘How the Ought became the Is’, Futures & OTC World Supplement, June 1998.

9 John P. Davidson III, chairman of the FIA Task Force to Promote Common Clearing in Chicago, interviews Paul G. Stevens, Jr, president and chief operating officer of the OCC, FIA Magazine, August/September 1997.

7 8

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History

During the late 1970s and early 1980s there were antoher two important developments. Firstly in 1977, the SEC allowed put options to become exchange-listed, dramatically expanding the range of tradeable options. The next important move came in March 1983, when the CBOE introduced index options on the CBOE-100 Index (later renamed the S&P 100 Index) – the first broad-based stock options contracts ever – and one of the most actively traded exchange-listed option, even today.

The next development was far less auspicious: the Wall Street meltdown of 1987. Up to this time, retail investors accounted for an estimated 90 percent of listed options activity – institutional investors just 10 percent. Unsurprisingly, when the stock markets plummeted in 1987, confidence in the market was sorely shaken.

The exchanges responded to these events by creating the Options Industry Council (OIC). A non-profit organisation, the OIC was designed to educate investors on the risks and rewards of options trading, giving them free access to educational videos, software, brochures and seminars. Despite their best efforts, it would take some years before confidence had been fully restored and volumes returned to pre-crash levels. But, in the intervening years, there were some striking developments that would radically alter the US equity options landscape.

Fighting fragmentation There may have been four options markets competing for a slice of the US options pie but, in practice, competition between them was limited, if not nonexistent. In the early stages of the market’s development, the exchanges rarely listed options contracts that were already traded on another exchange, although there was no rule that explicitly prevented them from doing so.

In 1977, the SEC had placed a moratorium on the listing of new equity options while it studied the market. In June 1980, it initiated a lottery system to allocate rights for trading new options.

Under the new arrangements, the exchanges would let the SEC know which

In 1977, the SEC allowed put options to become exchange-listed, dramatically expanding the range of tradeable options equity options they wished to list and the SEC would use a lottery to allocate the exclusive right to trade these options to specific exchanges.

Throughout the 1980s and into the 1990s, the system remained under review.

The SEC continued to hold the lotteries but, at the same time, it was applying pressure for the exchanges to move towards a system of multiple listings in which several exchanges would list options on the same underlying equities and compete to provide the best market.

The options exchanges failed to take the hint and in 1985 the SEC took action: it decided that the right to trade options on OTC stocks would not be allocated through a lottery, but they could be listed on multiple exchanges. In 1990, the SEC ended its lottery system for allocating options on exchange-listed stocks and ruled that henceforth any options listed for the first time on an exchange could be listed on another exchange. Finally, by the mid1990s the SEC lifted all restrictions on multiple listings.

The changes had only modest effects.

The exchanges still chose not to list options that had been allocated to other exchanges under the lottery system – and until mid-1999, about 60 percent of equity options were still traded on only one exchange.

Two developments were to change this: firstly the SEC and the US Justice Department filed suits against the four incumbents, arguing that there existed a "gentleman's agreement" among them not to compete. Secondly the International Securities Exchange was to arrive on the scene.

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Structured products by

Bank Vontobel:

Library: University Zurich, Santiago Calatrava

individual product architecture included.

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Modern times The arrival of two all-electronic markets, the DTB In Europe and ISE in the United States, were to dramatically revolutionise the options markets. Natasha de Terán charts their course

“W

e are heralding a new era in the options industry.

We are proud to be pioneers in moving the US financial markets into the 21st century,” said David Krell, co-founder of ISE and former president and chief executive officer, May 20001.

In 1998, ten of the largest equity derivative dealers in the US – including Goldman Sachs, Morgan Stanley and Deutsche Bank – announced that they would invest in the creation of an all-electronic options exchange – the International Securities Exchange (ISE).

This would list the most active options contracts traded on other exchanges – in other words, it planned to break the monopolies that the exchanges had enjoyed in many options listings.

In fact, in1999, the CBOE, AMEX, PHLX and PCX had gradually begun listing options contracts that were active on other exchanges. But the competition between them did not really heat up until the ISE options exchange opened for business in May 2000.

1

The ISE – a brief history In 1996, the then-chairman of E*Trade, William A Porter, and his colleague, Marty Averbuch, began planning an exchange based on the assumption that technology and fair market structure would enable better quality trading for investors. In 1997, they approached David Krell and Gary Katz, both then working at financial services consultant K-Squared Research LLC, to examine the feasibility of developing a new, electronic US options exchange.

In May 2000, ISE went live – the first transaction being a purchase of 20 SBC Communications October 45 calls. ISE was the first nationally-registered securities exchange to begin trading in the US for 27 years, the first fully electronic options market in the US and the first options marketplace to combine electronic trading with the principles of open-outcry pricing. Its transformative effect on the US options landscape cannot be overestimated.

Exactly a year after launch, ISE had traded its 25-millionth contract. By November the same year, after just 18 months of trading, it had become the third-largest US equity options exchange.

ISE launch heralds new era for US options market, Richard Irving, Financial News, 29 May, 2000.

On its second anniversary ISE achieved its target of listing equity options representing 90 percent of average daily trading volume in the US options industry. By mid-year, ISE had traded its 200-millionth contract and,

by March 2003, it had become the largest US equity options exchange, after average daily volume for February 2003 reached 710,218 contracts. In April of that year, the ISE became the world’s largest equity options exchange.

In January 2004, ISE was awarded the accolade of ‘Derivatives Exchange of the Year’ by Risk magazine for the second time in three years and, in March 2005, ISE became the first US securities exchange to sell its shares in an initial public offering.

In May that same year, it traded its 1 billionth contract.

In May 2006, ISE traded its 1.5 billionth options contract and set its sights on expanding beyond its core options business.

The relentless energy that had built up the exchange showed no signs of flagging – in September 2006, ISE adopted a holding company structure to provide a framework for growth. In partnership with key strategic firms, ISE went on to launch the

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ISE Stock Exchange with its first product, MidPoint Match®, a continuous, instantaneous, fully-automated and anonymous matching platform for trading stocks. In December, ISE Stock Exchange rolled out its fully displayed stock market, becoming the first fully electronic exchange to provide integrated access to non-displayed and displayed liquidity pools.

In April 2007, a month after trading its two billionth options contract, ISE debuted in the foreign exchange market with its new currency options product, ISE FX Options®.

By this stage, the US equity exchange landscape had transformed dramatically. The options industry had completed its conversion to decimalisation and the Boston and New York stock exchanges had entered the options market fray through their Boston Options Exchange and NYSE Arca subsidiaries. US options volume had reached a new record for the fifth consecutive year in 2007, when OCC cleared 2,862,826,218 contracts, almost four times the 726,727,939 contracts that it had cleared in 2000, the year of ISE’s debut. ISE had changed the US options market beyond recognition.

Eurex – leading Europe Europe had a late start in the equity options business, but has since made up for its tardiness – in spades.

In 1988, SOFFEX, the Swiss Options and Futures Exchange, pioneered electronic trading. The exchange based its trading activities on a fully electronic trading platform with an integrated clearing house. By the end of 1989, new futures exchanges were being planned in Norway, Italy and Spain, and London already counted on a relatively mature market in Liffe, but it was a German exchange that was destined to have the most dramatic impact on both Europe and the global stage.

In January 1990, financial reporters had gathered in Frankfurt to hear Rolf Breuer, a management board member of Deutsche Bank, announce that “a new era of bourse trading had begun in West 2

31

In January 2004, ISE was awarded the accolade of ‘Derivatives Exchange of the Year’ by Risk magazine for the second time in three years

Germany.”2 Breuer was speaking in his capacity of chairman of the Deutsche Terminbörse’s (DTB) supervisory board and was referring to the launch of Germany’s new futures and options exchange.

The DTB was to be West Germany's ninth securities exchange, but its first fully computerised bourse. The new exchange was to be more sophisticated and advanced than the existing futures exchanges in London and Chicago, and promised a radical departure from the traditional open outcry dominated market structures common at the time.

On its first day of trading in January 1990, more than 12,000 options on 14 leading West German shares were traded on the new exchange. It was an auspicious start, and just two months later, DTB was able to report having traded its 1 millionth contract.

At this time financial futures trading was already well-established on the Liffe floor in London, but the DTB was betting that the sophisticated electronics of its computerised trading system would make it more than a match for the traditional open outcry trading used in London.

West Germany Opens New Futures Exchange, Andrea Schwarzmann, Reuters, 26 January, 1990.

In November 1990, the DTB began trading Euro-Bund Futures and a new futures contract on the 30-share German stock index, DAX®, marking the first time financial futures contract had ever been traded on an exchange in the Federal Republic.

It was clear, only six months later, that DTB was going places: its options turnover was the highest in Europe. It had dislodged Switzerland's SOFFEX from the top spot, and had secured 19 percent of all European options turnover.

Over the next months DTB added to its equity product menu with options on DAX®Â and options on DAX® Futures. By January 1992, DTB was able to reflect on a highly successful first two years in business. A total of 15,369,364 contracts had been traded in 1991 – more than double the 6,798,558 contracts traded in 1990.

By the end of 1992, nearly half the world's futures and options volume was being traded outside the United States. This was good news for the DTB – but other European exchanges were also thriving; thus it was time to solidify the market’s ownership. In October 1993 Deutsche Terminbörse was for-

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mally folded into Deutsche Börse AG. That year, volume at the DTB rose to 50.2 million contracts, boosted by a 94 percent year-on-year volume rise in DAX® Options, already the most heavily traded option contracts in Europe. Gaining that accolade was no mean feat: by mid 1994 more than 120 equity index futures, options on futures and options on index contracts were trading on at least three dozen exchanges around the world.3 Even in these early days, the Frankfurtbased exchange was attracting a broad range of international participants. The news agency Reuters reported how “hordes” of American traders, “tired of chasing paper-thin profit margins on Wall Street”, had been flocking across the Atlantic to Frankfurt.4 Of the 53 institutions that joined the DTB at its inception on 26 January, 1990, only 11 were foreign-based. By early 1993, 79 institutions were participating, of which 29 were based outside Germany.

September 1997 marked another important change. Deutsche Börse and the

SWX Swiss Exchange agreed to merge their derivative markets, DTB and Soffex, under the new Eurex brand. The following June, and with a keen eye on the impending introduction of the new euro currency, Eurex listed the first equity index contracts of the Eurozone – the Dow Jones EURO STOXX 50® Index Options, the Dow Jones EURO STOXX 50® Index Futures, as well as futures and options on the pan-European market index, the Dow Jones STOXX 50® Index.

Within a year, the Dow Jones EURO STOXX 50® Index had established itself as the panEuro benchmark, and Eurex’s contracts had become the listed derivatives of choice for Eurozone equity index trading. In 1999, Eurex also began offering equity options and index products on Finnish and Nordic stocks.

By the end of that year, and less than a decade after its launch, Eurex had established itself as the largest derivatives exchange globally, with more than 379 million contracts traded. DAX® Options were its third most liquid contract; index derivatives and equity options accounting for

Volume at the DTB rose to 50.2 million contracts, boosted by a 94 percent year-on-year volume rise in DAX® Options, already the most heavily traded option contracts in Europe

3

Stock indexes on the march. 1 August, 1994, Futures (Cedar Falls, Iowa).

Influx US traders stimulates German options market, Erik Kirschbaum, Reuters, 13 April, 1993.

4

33

some 130.5 million of all the contracts traded on the exchange.

In February 1999, Eurex added Dutch, Italian and French equity options to its armoury and, by September, it had established a lead in options traded on Nokia. In November 2000, Eurex became the world's first exchange to break through the 400 million contract mark.

Nor did the action stop there. In February 2001, Eurex introduced sector indexes, launching eight new futures contracts on sector indexes of Dow Jones STOXX® and EURO STOXX® families, later adding options on the same sector indexes. In 2002, the exchange launched the first European Exchange Traded Funds® Futures and Options contracts. The same year, it introduced a designated market maker programme for its index products, expanded its sector product range and introduced longer term options on the more liquid underlyings. Unsurprisingly given this work rate, it was able to claim pole position in equity options trading – outpacing the CBOE – by year-end.

In 2003, Eurex expanded its range of Dutch and French options and launched futures and options on TecDAX®; it enhanced its clearing service by offering risk offsets between derivatives positions on same-sector equities and indexes. Bundling the margin collateral reduced the margin requirements for Eurex customers, by as much as 50 percent. Eurex also added further sector index products, and ended the year by becoming the first exchange to cross the 1 billion contract barrier.

In 2004, Eurex again extended its product range; it added an Italian index futures contract with the Dow Jones Italy Titans 30 IndexSM and listed individual Italian equity options. That December it also launched a new market-making model for European equity options trading, which would offer continuous quotation in all European equity, index and ETF options.

The following year, the exchange slashed its wholesale trading fee schedule, encouraging users to put through more block trades; it introduced futures and options on the Dow Jones STOXX® 600 Index and the pan-European midcap index, the Dow Jones STOXX® Mid 200 Index; it became the first exchange in Europe to offer trading in volatility futures when it launched futures

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on the pan-European VSTOXX®, the Swiss VSMI® and the German VDAX-NEW® in September and it introduced its first single stock futures (SSF) contracts.

In 2006 Eurex continued to expand its equity range, adding options on Swedish and Spanish equities. It also integrated Markit’s Dividend Forecasts in its pricing models and announced an incentive programme designed to increase client proprietary trading. By the end of the year it had traded more than 1.5 billion contracts, up 22 percent on the year. Its equity index derivatives segment rose by 45 percent to more than 487 million contracts and the future on the Dow Jones EURO STOXX 50® Index remained the strongest in the segment, with traded volumes of 213 million contracts.

By the beginning of 2007, Eurex had firmly established its position as Europe’s leading equity options exchange with an offering of 370 single stock futures and more than 190 equity options from nine countries. Eurex built on this success by adding single stock futures on Russian shares and futures on the RDXxt® USD – RDX Extended Index – an index calculated by the Wiener Börse AG (the Vienna Stock Exchange) comprising the 15 largest Russian depositary receipts traded on the London Stock Exchange. In May, it further expanded its portfolio by introducing the 16 SSF on the 16 GBP-denominated components of the Dow Jones STOXX 50® Index.

A transformative trans-Atlantic deal The year 2007 was to prove to be another pivotal one for Eurex and its users. In April, the exchange announced that it was to combine with ISE in a deal that would create the largest transatlantic derivatives marketplace with leading positions in index and equity derivatives in dollars and euros.

The deal was completed by the end of the year. On a combined basis, Eurex and ISE were the market leaders in individual equity and equity index derivatives worldwide. Eurex and ISE members would benefit from access to highly liquid products, spanning multiple asset classes and currencies.

By March 2008 it became clear just how large those benefits would be: together with OCC, the exchanges announced plans to create a transatlantic trading and clearing link that would enable Eurex customers to access ISE’s options market using their 5

14:58

By the beginning of 2007, Eurex had firmly established its position as Europe’s leading equity options exchange existing Eurex connections. Through this link, Eurex members will have access to the full suite of options products available at ISE and be able to execute orders in the ISE order book using their existing connectivity to Eurex.

Still Eurex continued to roll out equity products. In April, it launched futures on the DivDAX®, an index comprising the 15 DAX® constituents with the highest dividend yield, and introduced 13 new equity options on Belgian, Dutch, French and Spanish underlyings. The same month, it added a new interface, reducing average roundtrip times of future orders to 5 milliseconds, halving the times previously achieved. In June, it launched derivatives on the USD-denominated MSCI Russia Index and Dow Jones EURO STOXX 50® Index Dividend Futures, introduced a Multilateral Trade Registration (MTR) facility and a new deal-based pricing structure for equity options. (see pages 74 to 77 for further details).

The OTC markets At the same time as the US and European equity derivative markets were growing, so too the over-the-counter (OTC) equity derivatives were expanding fast.

In the mid-1980s, Bankers Trust had pioneered the use of equity derivatives in corporate finance, pitching the idea to companies of selling put options on their own stock in conjunction with stock buybacks.5 The idea was that if the stock fell, they would get put back to the company; if the company's share price rose, the company could use the premium proceeds to go into

the market and buy up stock.

By the early 1990s the OTC market was dominated by fairly simple products – equity forwards, swaps and options - and the OTC market was so small it had no formal measure (although, in 1992, a Deutsche Bank trader estimated OTC equity derivative volume at USD 40-150 billion.)6 Around this time, there was an emergent market in structured products, the most popular of which were principal-guaranteed bonds with equity kickers, consisting of call options on stock market indexes. These bondcall structures were being bought by pension funds and insurance companies in the US and continental Europe as way to play the equity markets.7 By 1996, the OTC market was expanding at a rapid pace. Popular OTC strategies included collars, basket options and total-return swaps. The International Swaps and Derivatives Association (ISDA) published its first set of Equity Derivatives definitions to support use of its Master Agreement documentation, and equity derivatives were again beginning to resurface in corporate finance.

UBS was involved in a large equity derivatives programme when it structured the Commit employee stock option plan for Deutsche Telekom as part of the company's USD 13 billion initial public offering, a programme that was designed to entice German employees to become Deutsche Telekom stakeholders. The corporate equity derivatives business gained further traction the same year, when US newspaper group Times Mirror Co. used equity derivatives to cash out its position in Netscape Communications Corp.

Tailor-made: in an increasingly commoditised market, the use of equity derivatives in corporate … Robert Clow, Institutional Investor 1 June, 1997.

How appetites are growing for OTC equity derivatives, William D. Falloon, Futures, 15 January, 1992.

7 Hedging your derivatives doubts, Claire Makin, Institutional Investor, 1 December, 1991.

6

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WISH YOU WERE HERE

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BLOOMBERG TRADEBOOK believes that the information herein was obtained from reliable sources but does not guarantee its accuracy.

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Communicated by Bloomberg Tradebook Europe Limited, registered in England & Wales No. 3556095, authorized and regulated by the UK Financial Services Authority No. 187492. This communication is directed only at persons who have professional experience in the investments which may be traded over the systems and certain high net worth organizations.

Bloomberg Tradebook LLC member of FINRA (www.finra.org)/ SIPC/NFA. Bloomberg Tradebook do Brasil is the representative of Bloomberg Tradebook LLC in Brazil registered with the BACEN. Bloomberg Tradebook Services LLC, Bloomberg Tradebook Australia PTY LTD ABN 36 091 542 077 ACN 091 542 077, Bloomberg Tradebook Do Brasil LTDA., Bloomberg Tradebook Canada Company Member of CIPF, Bloomberg Tradebook Limited, Bloomberg Tradebook Hong Kong Limited the first ATS authorized by the SFC–AFU 977, Bloomberg Tradebook Japan Limited member of JSDA/JIPF, Bloomberg Trading Services Japan LTD, Bloomberg Tradebook Singapore Pte Ltd Company No. 200104338R, Bloomberg Trading Services (Singapore) Pte Ltd Company No. 200101232G. Bloomberg Tradebook Bermuda LTD, licensed to conduct Investment Business by the Bermuda Monetary Authority.

The BLOOMBERG PROFESSIONAL service (the “BPS”), BLOOMBERG Data and BLOOMBERG Order Management Systems (the “Services”) are owned and distributed locally by Bloomberg Finance L.P. (“BFLP”) and its subsidiaries in all jurisdictions other than Argentina, Bermuda, China, India, Japan and Korea (the “BLP Countries”). BFLP is a wholly-owned subsidiary of Bloomberg L.P. (“BLP”). BLP provides BFLP with all global marketing and operational support and service for the Services and distributes the BPS either directly or through a non-BFLP subsidiary in the BLP Countries. The Services include electronic trading and order-routing services, which are available only to sophisticated institutional investors and only where the necessary legal clearances have been obtained. BFLP, BLP and their affiliates do not provide investment advice or guarantee the accuracy of prices or information in the Services. Nothing on the Services shall constitute an offering of financial instruments by BFLP, BLP or their affiliates. Bloomberg Tradebook is provided by Bloomberg Tradebook LLC, a wholly-owned subsidiary of BLP, and its affiliates and is available on the BPS. BLOOMBERG, BLOOMBERG PROFESSIONAL, BLOOMBERG MARKETS, BLOOMBERG NEWS, BLOOMBERG ANYWHERE, BLOOMBERG TRADEBOOK, BLOOMBERG BONDTRADER, BLOOMBERG TELEVISION, BLOOMBERG RADIO, BLOOMBERG PRESS and BLOOMBERG.COM are trademarks and service marks of BFLP or its subsidiaries. BLOCK HUNTER, BWAP, DEFINING LIQUIDITY, LIQUIDITY DOME and TRIGGER TRADING are trademarks and service marks of BLP.

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The events of late 2007 and early 2008 have emphasised the advantages of listed and/or cleared derivatives markets like never before Equity derivatives were also playing a strong supporting role in takeovers, to fine-tune financing for acquisitions or to lock-in total acquisition costs in the period between announcement and closing day.

At this time, banks with strong private banking franchises were also pitching equity derivatives’ monetisation strategies, such as zero-cost collar transactions, to their high net worth clients. Listed warrants and options had firmly taken root in continental European markets, particularly in Germany and Switzerland, where exchange-listed warrants, in particular, had become a fixed part of the scene.

A few more exotic structures were also building momentum. These included the low exercise price options (Lepo) or zerostrike product, which was particularly popular in Switzerland. ’Deep in the money‘ calls or ’deep out of the money‘ puts were generally written on stock indexes and mimicked the effect of owning the underlying stocks, but avoided the transaction costs or management fees. Another product sold into the Swiss market was the reverse convertible – a bond having a higher than normal interest-rate coupon, which converts to stock only if the market drops below the strike price.

Eyeing the OTC markets For all that the OTC markets were clearly booming, it was not until 2002 that ISDA was to measure the market; at the end of June 2002 it estimated the global OTC equity derivatives market was worth some USD 2.3 trillion in notional terms. Later the same year, ISDA expanded the product

range covered by its Equity Derivatives definitions to new products such as barrier instruments, Bermuda options and forwards.

Long before ISDA began calculating the OTC’s market size, the regulated exchanges had started rolling out their own OTC offerings. Aware that the unique advantage of OTC trading was its inherent flexibility, the CBOE and AMEX began offering custom-tailored options on a number of widely held and heavily traded stocks in the mid-1990s.

Around the same time, DTB started a ‘block trade facility’ allowing members to input large-volume OTC trades into the clearing system. Both products boasted other advantages over and above their OTC alternatives, including fungibility, price discovery, a clearing-house guarantee and the elimination of counterparty risk.

Today, of course, these exchange-based OTC facilities are more important than ever.

As we will explore later in this publication, they have since expanded very substantially in scope and application and their takeup is growing incrementally.

The events of late 2007 and early 2008 have emphasised the advantages of listed and/or cleared derivatives markets like never before and have thrown into relief the importance of hedging, of risk diversification and of seeking out uncorrelated asset classes. As you will find in these subsequent chapters and case studies, the products and services now offered by exchanges such as Eurex and the ISE, as well as central counterparties, such as Eurex Clearing, are helping many an investor to realise these benefits.

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Exploiting equity index derivatives Deutsche Bank’s Pamela Finelli and Mehdi Alighanbari outline the development of the listed index futures and options markets in Europe, and illustrate some common indexbased strategies that can help de-risk equity portfolios

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I

n recent years, European investors have shifted away from index futures and options on the single-country indexes (DAX®, CAC 40®, IBEX 35®, etc) instead moving to pan-European benchmarks.

In 1999, German index products dominated activity in Eurex-listed index products; turnover in the exchange’s DAX® Futures and Options contracts was more than ten times higher than trading in its Dow Jones EURO STOXX 50® Index contracts. But Eurex Dow Jones EURO STOXX 50® Index Futures and Options have long since become the contracts of choice among investors seeking exposure to the pan-European equity market. The Eurex Dow Jones EURO STOXX 50® Index Futures contract is now the dominant product.

Recent average daily turnover in the contracts has been close to EUR 46 billion, compared to around EUR 28 billion for DAX® Futures.

Index futures Liquidity concentration is an important feature of the European index futures market. Over the past few years, ease of trading and liquidity have become more important to investors than other considerations, such as tracking error. Moreover, index futures have become the preferred instrument for those seeking to trade index beta, to hedge portfolio returns, to gain equity exposure or to manage large-scale portfolio transitions.

One of the reasons behind the attraction of the Eurex Dow Jones EURO STOXX 50® Index Futures is that roll pricing and the trading of the roll relative to fair value has been steady over the past few years. In general, the quarterly rolls have tended to trade at a modest discount to fair value, (apart from a short period from March 2004 to the December 2005 expiry). Even in the context of trading expensive to fair value, for long investors, this peaked at less than 10bps. Looking at the individual quarterly roll trends from March 2002 to June 2008 (see figure 1); we find that the

39

Liquidity concentration is an important feature of the European index futures market

maximum deviation with respect to a single quarterly roll was 10bps (the chart below shows the costs over one year, ie, four rolls for rolling a Dow Jones EURO STOXX 50® Index Futures position). This occurred during the March 2008 expiry and, to a certain extent, the dramatic increase in dividend risk in the roll was down to the problems then impacting on European banks. Looking at roll costs over time (we have used an example of a one-year moving window) we can see that this has tended to favour

holders of long futures positions: the aggregate discount to fair value over the past year reached close to 48bps.

We believe that dividend expectations and dividend risk play an important part of determining roll risk and roll timing.

Investors will typically wait until two to three days before expiry before rolling their contracts – usually because this can lower the risk in forecast dividends. Eurozone dividends tend to be quite lumpy and peak dividends tend to occur in the first quarter.

Figure 1: roll costs over one year of the Eurex Dow Jones EURO STOXX 50® Index Futures 20.0

10.0

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Dow Jones EURO STOXX 50® Index Futures roll costs over 1 year

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close to EUR 5.5 billion of open interest in STOXX® Sector Futures contracts, and some of the other key sectors, such as banks, oil and gas and telecommunications, have become reasonably active. Indeed, since the end of 2006, sector open interest has risen by more than 43 percent. As investors continue to seek diversification opportunities we expect that sector futures usage will grow.

It is interesting to compare the liquidity trends in Europe with those in the US market. The futures market in Europe clearly matches the trading activity in the US and almost certainly has a greater breadth of product when it comes to sectors. However, in the US there is better liquidity in small and mid cap futures, which account for

around 15 percent of all US equity futures turnover. This reflects the US investor preference for trading different sizes and stylebased trading. In addition, the US has significantly better liquidity in other delta-1 products, such as exchange traded funds (ETF). Turnover in the US ETF market is now in excess of USD 100 billion per day, while in Europe, where the ETF market is much younger in terms of development and still growing at a rapid pace, it is around USD 2.5 billion.

Index options There is no doubt that, in conjunction with the depth of the index futures markets on Eurex, investors have benefited from the liquidity in the index options market.

Figure 2: growth of Eurex Dow Jones EURO STOXX 50® Index Futures and Options a) volume b) open interest a)

Average monthly volume - options and futures

Millions 70.0

60.0

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Contracts

This also tends to represent the peak time with respect to forecast dividends, since close to 94bps of expected dividends fall in the March to June 2008 roll.

Quite naturally, the current turmoil has brought dividend issues to the forefront of investors’ minds. There is a relatively longstanding over-the-counter (OTC) market in dividend swaps, which can be used to hedge out dividend risk. However, it has tended to lack transparency (although this has evolved considerably over the past five years).

In order to better capture the needs of the market and offer greater transparency and liquidity, Eurex recently introduced Dow Jones EURO STOXX 50® Index Dividend Futures. This unique tool complements the index futures and allows investors to hedge away dividend risk or to take a view on the future direction of dividends. This is currently a niche market, but as concerns over dividend risks rise and dividend strategies become more widely understood, the product should gain traction and value as a trading tool.

As markets have shifted over the past year, there has been a dramatic evolution in sector performance, and sector investing has proliferated. This has probably been driven by the wide divergence in performance. For example, the basic resources sector outperformed the benchmark by more than 46 percent over the past year, while the troubled banking sector has underperformed the index by more than 24 percent. As a result, investors have been making increased use of the Eurex-listed STOXX® Sector Futures, using the instruments to implement strategic portfolio overlays that reflect the rapidly changing fundamentals within the European stock universe.

The basic resources sector is dominated

by UK-listed stocks, which account for close to 70 percent of the index. Using listed futures to gain or hedge exposure to this sector has clear benefits: investors can trade the whole index in euros without having to worry about currency conversion, and also avoid the 50bps of stamp duty that would have been incurred if they traded all the underlying UK names. We expect that this is one reason why the basic resource sector futures currently have open interest of more than EUR 640 million. Overall, there is now

40.0

30.0

20.0

10.0

0.0 1998

b)

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008*

Open interest - options and futures

Millions 50 45 40 35

Contracts

40

17/9/08

30 25 20 15 10 5

1998

1999

2000

2001

2002

Source: DB estimates and calculations, Reuters *2008 volume is the monthly average through March **2008 open interest as of 31 March, 2008

2003

2004

2005

2006

2007

2008**

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Figure 3: the historical one-year correlation of the Dow Jones EURO STOXX 50® Index and the correlation of the Dow Jones STOXX® 600 Benchmark Index 1.00

0.98

Correlation to the DJ EURO STOXX 50® Index

0.96

0.94

Correlation

0.92

DJ STOXX® 600 FTSE 100 DAX® CAC 40® IBEX 35®

0.90 0.88

0.86

0.84

0.82

0.80 1998

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

(using daily index returns) 3-month 1-year 0.98 0.97 0.94 0.92 0.99 0.96 0.98 0.98 0.95 0.94 Correlations through Apr-08, using daily returns

2-year 0.97 0.92 0.97 0.98 0.93

Sources: DB estimates and calculations

Among all European benchmark indexes, liquidity is by far the greatest in the Eurex Dow Jones EURO STOXX® 50 Index Options.

The result is that trading options on Eurex’s equity indexes is already popular among a broad range of investors seeking exposure to equity benchmarks. Pension funds and insurance companies often buy index puts to hedge long-term equity risk in their portfolios; asset managers employ index options for yield enhancement by overwriting existing long index positions; hedge funds, who often view equity volatility as an asset in its own right, trade index options and delta-hedge to speculate on future volatility levels.

More specifically, the concentration of liquidity in the benchmark contracts has led to deep liquidity and narrow bid/ask spreads in Eurex Dow Jones EURO STOXX 50® Index Options – indeed it is now possible to trade the contracts in size without moving markets materially, making the contracts especially appealing to large institutional investors.

The large-cap Dow Jones EURO STOXX 50® Index has historically been highly correlated to the broad market Dow Jones STOXX® 600 Index, as well as to many major European country indexes.

Investors seeking pan-European exposure through options will often find that the liquidity benefits of using the Dow Jones EURO STOXX 50® Index Options outweigh the potential risk of tracking error to their actual benchmark. Furthermore, and

because liquidity often dries up in periods of stress – as indeed it did in many of the more esoteric equity underlyings during the peaks of the 2007/2008 crisis – trading benchmark options has particular appeal for investors concerned about liquidity.

Dow Jones EURO STOXX 50® Index Options are available on a broad range of expiries and strikes, which means it is possible to use the options to express very market-specific views. The options are listed for maturities ranging from less than one month, all the way out to 2015. A ‘heat map’ of the open interest profile on April

24 (figure 4) shows that positions are most concentrated for options expiring in the next three to 12 months, and the most common strikes are those within 10 percent of the index’s current level.

Notably, there is materially more open interest at far out-of-the-money downside strikes than upside strikes, which can likely be explained by investor interest in using index options for portfolio hedging. Demand for index puts is typically higher than for calls, evidenced by put/call open interest ratios that are generally greater than one for most European indexes. For the Dow Jones

Dow Jones EURO STOXX 50® Index Options are available on a broad range of expiries and strikes, which means it is possible to use the options to express very market-specific views

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Figure 4: Dow Jones EURO STOXX 50® Index Options open interest heat map (open interest in contracts as of 24 April, 2008)

2y-5y 1y-2y 3m-1y 1m-3m

Time to options expiry

5y-10y

210%

200%

190%

180%

170%

160%

150%

140%

130%

120%

110%

100%

90%

80%

70%

60%

50%

40%

30%

20%

1m

Option strike as % of index level 0 - 0.5

0.5 - 1

1 - 1.5

1.5 - 2

2 - 2.5

2.5 - 3

Millions of options contracts Sources: DB estimates, Eurex data

EURO STOXX 50® Index on our sample day in figure 4, more than 20 percent of the total open Dow Jones EURO STOXX 50® Index Options positions had strikes below 80 percent of the index’s current level.

Managers concerned about short-term portfolio volatility often feel compelled to sell their positions even if their long-term fundamental views have not changed.

Adding index options to an equity portfolio can help de-risk it in several ways without necessarily forcing managers to abandon their core long-term strategies.

Hedging with long puts In 2007, portfolio protection came back into vogue as investor complacency waned amid uncertain markets. We believe that one of the simplest and most effective ways to hedge an equity portfolio in such circumstances is with index options.

Adding an index put to a long equity portfolio can significantly reduce downside risk, while maintaining market exposure. A long equity investor that hedges with puts does not want the option to finish in-themoney at expiry, but the protection offered by the index option can help the investor weather turbulent times. A long put position will incur a loss of the up-front premium paid should the option finish outof-the-money at expiry.

Put strike and maturity selection is important for intelligent portfolio protection. Investors need to consider the type of risk they are protecting against, ie, crash risk vs. next leg down – how much downside can a long equity portfolio sustain? A long-dated, far-out-of-themoney index put can be effective for reducing P&L volatility. Since the put strike is well below the current index level, the

up-front option premium is lower, but the put will have long vega exposure and therefore may benefit from both a decline in the index level and an expected increase in implied volatility in a severe market downturn.

The mark-to-market P&L gain offered from index ’crash’ puts can be material.

Figure 5 shows the hypothetical P&L for a systematic long Dow Jones EURO STOXX 50®

Put strike and maturity selection is important for intelligent portfolio protection. Investors need to consider the type of risk they are protecting against

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Cheapening index protection Multi-leg options strategies can help tailor hedges based on specific market views and allow investors to reduce the cost of their index protection. Cheapening strategies became especially popular when index implied volatilities rose sharply at the height of the credit crisis.

During such times of stress, assessing different protection structures makes particular sense. For example, rising implied volatilities are often accompanied by a steeper implied volatility skew, which helps in pricing long put spreads (note that there is still a risk of losing the premium paid for the put spread). This strategy was popular following the sharp sell-off in January 2008, when equity implied volatilities rose to five-year highs. Investors who believed that it was unlikely equities would fall much further, and thus saw a need for only moderate downside protection, were able to sell away the far outof-the-money put, reducing the cost of the nearer strike put significantly, as the implied volatility of the short put at the lower strike was high relative to the nearer-to-the-money put.

Those who thought a sustained equity rebound was unlikely given the gloomy market sentiment at the beginning of 2008 will have found short call/long put collar strategies more appropriate. Forfeiting potential upside in exchange for receiving a healthy premium for selling calls on equity indexes provided a potentially attractive risk/reward scenario, again offering less expensive downside protection when put prices were high.

Yield enhancement through index overwriting Selling index call options (call overwriting) on an existing long position is an efficient risk-reduction technique that provides an alternative to re-allocating shares in volatile markets.

Figure 5: hypothetical MTM P&L from systematic Dow Jones EURO STOXX 50ÂŽ Index long put strategy (6m maturity options, rolled every 3m for various options strikes) 200

May - Jun 06 sell-off

100 Feb / Mar 07 mini-crash

Correlation

Index put strategy, assuming that an investor buys one six-month expiry put and rolls the position every three months. The P&L is expressed in index points. The analysis shows that even a put struck at 80 percent of spot can generate mark-to-market gains during times of market stress.

Aug 07 credit crunch begins

-100

-200

-300

-400

St = 95% St = 85%

Extreme volatility in late Jan 08

St = 90% St = 80%

-500 Jan 06

May 06

Sep 06

Jan 07

May 07

Sep 07

Jan 08

P/L is expressed in index points. Investors should note that this analysis is hypothetical in nature, conducted using mid-market implied volatilities Sources: DB estimates and calculations.

Overwriting can allow investors to retain their long-term exposure while simultaneously gaining a steady income from call premiums in exchange for capping short-term upside potential. The yield enhancement from writing calls provides a cushion against downside moves and effectively de-leverages the portfolio without forcing the sale of underlying positions.

We have found that returns from overwriting European indexes generally fall short of index returns in bull markets, but exceed them in sideways and bear markets.

Less obviously, call overwriting strategies can also outperform in periods of heightened implied volatility levels. These properties make call overwriting strategies particularly compelling in uncertain times.

The primary risk of overwriting is missing out on sharp upside moves, but portfolio managers using systematic overwriting strategies mitigate the risk of underperformance in downturns by accepting a greater risk of underperformance during periods of unanticipated positive performance times.

Conclusion Several years of rarely uninterrupted calm ended dramatically in the second quarter

of 2007 when the credit crunch started to unfold and volatility returned abruptly to the equity markets. Long-only equity fund managers became concerned about redemptions in the face of higher volatility and lower returns. Elsewhere, a number of hedge funds were forced to de-leverage their portfolios.

We expect that these dramatic shifts in equity volatility will result in an increased focus on effective risk management strategies – in particular, index-based strategies will continue to be a popular topic in the equity investment community.

It is already apparent that liquidity in the key listed equity index products has concentrated on the Eurex platform. We expect that this will remain the case, and that the main liquidity growth will now occur in products such as exchange traded funds, and the related futures contracts, such as those listed on Eurex.

Another vital area that will determine investor use of futures will be product innovation, and from a European perspective it is already clear that Eurex has a leading position here, having already introduced many important new products over the past few years.

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Underlying index

DJ EURO STOXX 50® Index DJ EURO STOXX® Select Dividend 30 Index DJ STOXX 50® Index DJ STOXX® 600 Index DJ STOXX® Large 200 Index DJ STOXX® Mid 200 Index DJ STOXX® Small 200 Index DJ EURO STOXX® Sector Index DJ STOXX® 600 Sector Index DJ Sector Titans IndexSM DJ Global Titans 50 IndexSM (EUR) DJ Global Titans 50 IndexSM (USD) DAX® DivDAX® MDAX® TecDAX® SMI® SMIM® SLI® OMXH25 MSCI Russia Index RDXxt® USD – RDX Extended Index

Futures

Futures

Futures

Options

Options

Options

Contract value per index point of the underlying

Minimum price change – points

Minimum price change – value

Contract value per index point of the underlying

Minimum Minimum price change price change – points – value

EUR 10 EUR 10 EUR 10 EUR 200 EUR 200 EUR 200 EUR 200 EUR 50 EUR 50 USD 100 EUR 100 USD 100 EUR 25 EUR 200 EUR 5 EUR 10 CHF 10 CHF 10 CHF 10 EUR 10 USD 25 USD 25

1 0.5 1 0.1 0.1 0.1 0.1 0.1 0.1 0.1 0.1 0.1 0.5 0.05 1 1 1 1 0.5 0.1 0.5 0.5

EUR 10 EUR 5 EUR 10 EUR 20 EUR 20 EUR 20 EUR 20 EUR 5 EUR 5 USD 10 EUR 10 USD 10 EUR 12.50 EUR 10 EUR 5 EUR 10 CHF 10 CHF 10 CHF 5 EUR 1 USD 12.50 USD 12.50

EUR 10 EUR 10 EUR 10 EUR 200 EUR 200 EUR 200 EUR 200 EUR 50 EUR 50

0.1 0.1 0.1 0.1 0.1 0.1 0.1 0.1 0.1

EUR 1 EUR 1 EUR 1 EUR 20 EUR 20 EUR 20 EUR 20 EUR 5 EUR 5

EUR 100

0.1

EUR 10

EUR 5 EUR 200 EUR 5 EUR 10 CHF 10 CHF 10 CHF 10 EUR 10 USD 25

0.1 0.01 0.1 0.1 0.1 0.1 0.1 0.1 0.1

EUR 0.50 EUR 2 EUR 0.50 EUR 1 CHF 1 CHF 1 CHF 1 EUR 1 USD 2.50

For detailed contract specifications of ISE options, please refer to: www.ise.com > options exchange > products traded

Deutsche Bank Deutsche Bank is a global investment bank with a strong private client franchise. A leader in Germany and Europe, the bank is expanding in North America, Asia and key emerging markets. Within Deutsche, the global markets division is responsible for fixed income, equity, commodity, foreign exchange, derivative and money market origination, sale, structuring and trading. Deutsche’s equity derivatives group provides investment and risk management solutions. The awardwinning platform offers a broad spectrum of market-driven products, including exchange traded and OTC vanilla derivatives as well as synthetic and complex equity derivatives, to a wide array of institutions, hedge funds, corporates and retail clients.

Pamela Finelli Pamela is Deutsche Bank’s European head of equity options strategy. For the past nine years she has been part of Deutsche’s equity derivatives strategy team, which provides indepth analysis and research on equity options, volatility, correlation and dividends.

Pamela is also one of the lead architects for the team’s award-winning equity derivatives website, ederivatives.db.com. Pamela holds a BS degree in business from Pennsylvania State University in the US.

Mehdi Alighanbari Mehdi is an equity derivatives strategist at Deutsche Bank, London. He holds a PhD degree in aeronautics and astronautics from Massachusetts Institute of Technology and a financial technology certificate from MIT Sloan School of Management.

Contact: pam.finelli@db.com mehdi.alighanbari@db.com

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Singling out the future Single stock futures have proved to be one of the most successful exchange traded contract launches in recent years. Altura Markets’ Ricardo Dias de Sousa explains where, when and how to use them

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S

ingle stock futures (SSF) have proved to be one of the most successful exchange traded contract launches in recent years. The instruments offer a wide range of benefits, including hedging, speculation, arbitrage, diversification and tax management opportunities, among others. The products were eagerly awaited by the industry and both volumes and open interest have increased steadily since their launch at the turn of the century.

In this chapter we will explain why investors should use SSF, and what makes them competitive alternatives to existing products.

SSF are derivative products, meaning that their value is ‘derived’ from an underlying asset, in this case, cash equities. The formula used to price SSF is as follows: Future Price= Spot Price + Cost of Carry – Dividend It can also be written as follows:

F = [S – PV(D)] * er(T-t)/365 Where: • F: futures price • S: stock price • t: current date • T: expiration date • PV(D): the present value of any dividends entitled to the holder of the underlying between t and T • r: the annualised risk-free rate • e: the base of the natural log In other words, a SSF contract should be worth the same as the underlying cash asset, plus the financial benefit derived from not having to hold the stock (the cost of carry), minus the periodic gains one would be entitled to if one were to own the stock – such as any dividend payments. In the eventuality there was a deviation from the fair value of an SSF, arbitrage possibilities would

47

One could theoretically replicate an SSF trade by using options, but SSF offer a cleaner and more efficient means of doing so emerge – one could buy whichever were cheaper, the stock or the future, and sell the more expensive, thus making a profit without incurring any risk.

With this very simple formula in mind, we can explain the most common reasons for entering into an SSF transaction – namely to increase leverage; to put on long/short strategies; to engage in dividend trading; to support stock lending activities, or to hedge.

As can be deduced from their name, SSF are futures contracts linked to individual equities, giving the SSF purchaser the right to acquire the underlying stock at a given time in the future. The contract has zero value at the time the trade is struck, but over time variations in the underlying equity price will add value to one side of the trade in the same proportion that it reduces the value of the other.

One could theoretically replicate an SSF trade by using options, but SSF offer a cleaner and more efficient means of doing so. Using the options market as an alternative, a trader would need to buy a simultaneous put-andcall option on an equity at the same strike price. He would then need to monitor both positions and post margin premia against them for the duration of the trade.

The SSF achieves the same effect in a single transaction, with less execution risk, at lower cost and with less onus on the position management function. Two other benefits that SSF have, over and above options, are the linear relationship between the underlying asset and the future and the fact that there are no premium payments to be managed and funded in SSF trades.

Shorting One of the key benefits of SSF is that they offer an easy means of selling or ‘shorting’ equities. There are other means of shorting equities, but SSF offer a very efficient shorting mechanism for several reasons. The investor is only obliged to deliver the asset at the specified delivery date, meaning that he or she has until settlement date to buy the underlying asset and deliver it to the buyer.

Thus, he or she can go short through SSF if he or she believes that the underlying referenced asset will depreciate over the term of the trade. This can either be done on an outright basis, or as a long/short trade in combination with the purchase of an equivalent volume of a related asset that the investor believes is going to perform better. In this trade, the underlying equity of the SSF sold position doesn’t actually have to fall – it just has to underperform the long equity or SSF position. If the short SFF position goes up, but the long position does better, the gains on the latter will more than compensate the losses on the former.

Dividend trading Dividend payments form a core component of the simple formula used to price SSF – they are represented by the PV(D) on our formula above. However, future dividend payments are by no means always certain at the time of trading, meaning that the instruments can be used to exploit dividend expectations. For instance, take two investors with different dividend expectations entering into an SSF trade. When the dividend is announced, one of the sides will benefit from

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REDUCE YOUR DOCUMENTATION RISK Donaldson Legal Consulting are specialist negotiators of derivatives documentation.

In these challenging times it is more important than ever to know that your business is protected against as many risks as possible. We have extensive in-house experience which allows us to offer a premier service at a competitive price.

Our expertise includes: • Drafting and negotiating ISDA Master Agreements, Commodity Agreements, Brokerage Documentation, Give-up Agreements, ETD Clearing Agreements, Structured Confirmations, GMRA, Stock Lending Agreements and more; • Training in Derivatives Documentation; • Assistance in special projects; • “In-house” style legal services for fund managers

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its better forecast at the expense of the other. In cases where there is certainty on future dividend payments, other related trading opportunities arise. For instance, because of fiscal differences between jurisdictions, the net dividend payments realised by the two parties can be different even when the gross value is the same.

Looking at the formula in terms of dividend:

PV(D) = S – F / er(T-t)/365 This gives the implied dividend expectation for the market. For a larger dividend expectation, the spot price (S) should be higher, or the future price (F) should be lower. Thus, one should buy the former and sell the latter.

Stock lending The other term of the pricing equation that is usually perceived as a known, is the cost of carry – the small r in our formula. This is the financial and opportunity cost incurred by holding the stock. Of course, different investors will have different costs of funding – some equity managers will change their cash holdings for SSF in order to finance themselves advantageously or in order to reinvest the proceedings elsewhere without having to sacrifice any expected gains of holding the stock (though they will, of course, give up the dividend if any is paid).

r=

(T-t)/365

√F / {[S – PV(D)] *e}

This gives the implied rate for stock lending.

Index fund management Managers running index funds, or investors tracking indexes, will often find SSF a useful means of adding to or subtracting from the index, creating customised exposures.

Portfolio management Investors working to long-term investment horizons may believe that individual securities will suffer from poor short-term price performance. They can use SSF to exploit these shorter-term market movements.

Hedging As the formula implies, the underlying cash equity and the SSF price move in the same direction. Holding one and selling the same volume of the other will thus immunise a portfolio from price fluctuations. Sometimes an investor will want to hold a share in his portfolio, but freeze its price. Because explicit commissions are usually cheaper in the futures market, it will usually be cheaper to hedge the position here than to trade in and out of the position in the cash market.

A quick look at open interest patterns will reveal that SSF liquidity tends to concentrate in the names that are most actively traded in the cash market. However, the vast majority of the volume traded in SSF is traded over-

49

the-counter (OTC) between investors and market makers and then given up to exchanges such as Eurex.

The role of the market makers is to provide liquidity. Some investors will request SSF prices directly from their broker-dealers, while others will choose to access the market through voice-brokers, which will in turn canvas broker-dealers’ ‘delta-1 desks’ to search out the best bids and offers.

The ‘delta-1 desks’ at brokers-dealers then put their balance sheets to work, often converting cash trades into futures and viceversa, without assuming any directional risk, thus the name ‘delta-1’ (bearing only dividend and interest rate risk).

As stated above, most volume is traded OTC, but typically the trades are then registered at the exchange and the clearing-house – in this case, Eurex Clearing – then steps in as a central counterparty (CCP), eliminating the bilateral credit risk and allowing the trade to be concluded anonymously. The CCP introduces a number of other benefits, including netting, margin offsets between qualifying positions, independent pricing and margin management, a reduction in operational risk and streamlined back-office processes.

Furthermore, many exchanges impose fee caps, which allow large block trades to be processed through the exchange in a costefficient manner Eurex has played an important role in stimulating the increase of usage of SSF. The

Pricing and trading mechanism of SSFs • When entering into a SSF contract, an amount of initial margin must be deposited by both the buyer and the seller. Currently, the initial margin of the vast majority of Eurex SSFs is between 10 and 15 percent of the underlying value.

• Due to cross margining, the margin requirement may even be lower if you also hold certain offsetting positions within one margin class or margin group.

• Each day the profit or loss made that day must be transferred between the buyer and seller (variation margin).

Initial margin Buying Client Variation margin

Buying Clearing Member

Initial margin

Initial margin

Variation margin

Variation margin

Selling Clearing Member

Initial margin Selling Client Variation margin

• Leverage effect of futures Investment Stocks SSFs Jun 08

Amount + Deutsche Bank + DBKF

100 shares 1 lot (100 shares)

Initial margin per share (EUR) NA 7.85

Price (EUR) 12/03/08 73.35 69.86

10/04/08 74.58 70.896

P/L per share (EUR) 1.23 1.04

P/L Total (EUR) 123.00 103.60

Capital initially invested (EUR) 7,335.00 785.00

Return rate 1.68% 13.20%

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Eurex has played an important role in stimulating the increase of usage of SSF

exchange has listed SSF on hundreds of different underlying stocks and introduced price quotation systems with four decimal places.

Furthermore, the exchange manages the corporate action processes and provides userfriendly trading platforms and tutorial seminars, all of which have helped propel the market forward. Combined, these efforts have enhanced the attraction of SSF, making them the number-one choice for shorting equity assets.

Altura Markets Altura is a joint venture owned by BBVA and NEWEDGE. The brokerage firm is based in Madrid and provides the complete range of execution and clearing services on all the world's listed derivatives exchanges. It offers institutional clients brokerage services in interest rates, equity, currency, commodity and energy products. Altura was born from a joint BBVA and Calyon financial project to create the first Hispanic broker with an integrated global network that links knowledge and expertise.

Ricardo Dias de Sousa Ricardo is a sales-broker at Altura in Madrid.

He joined the company in 2006, having previously worked for close to a decade as an equity and futures sales-broker. He holds a Master in finance from ISCTE in Lisbon.

Contact Ricardo.SOUSA@alturamarkets.com

Cash equitisation Short selling without borrowing stocks

Leverage

Hedging

Costefficient SSFs

130/30 strategy

Altering exposure without rebalancing Dividend trading

Pairs trading

Eurex Single Stock Futures Contract Standards Austrian, Belgian, British, Dutch, Finnish, French, German, Greek, Irish, Italian, Norwegian, Portuguese, Russian, Spanish, Swedish, Swiss and US equities.

Contract Sizes 1, 10, 50, 100, 500 or 1,000 shares.

Settlement Cash settlement, payable on the first exchange day following the Last Trading Day. Minimum Price Change EUR 0.0001, EUR 0.001, EUR 0.01, CHF 0.0001, CHF 0.001, CHF 0.01, GBp 0.01, USD 0.0001, USD 0.001 or USD 0.01.

Contract Months Up to 36 months: The 13 nearest successive calendar months as well as the two following annual months of the December cycle thereafter.

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Options on the rise Barclays Capital’s Aaron Brask explores the equity index and single stock option universe and explains how the instruments can be used

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N

ot surprisingly, liquidity in the equity derivatives market has grown exponentially. As an example, we note that liquidity in the Eurex Dow Jones EURO STOXX 50ÂŽ listed options contracts has exploded; since launch a decade ago, traded volume has risen to more than 1.5 million contracts per day1.

Much of this growth has been driven by new products and strategies. Indeed, innovation by exchanges, dealers, fund managers and corporates has led to more products and strategies, and, in consequence, greater liquidity. Here, we discuss some of the traditional and non-traditional applications through which different end-users can usefully deploy equity options.

For long-only fund managers, the first and probably most popular strategy is buying protection. This is usually done in the form of a put option. As the world is long equity by default, it is only natural for investors to want to hedge the associated risk.

Accordingly, there is a constant demand for put options from insurers, pension funds and other long-only equity portfolio managers.

Depending upon individual motivations and constraints, investors can choose between longer- versus shorter-dated puts

Innovation by exchanges, dealers, fund managers and corporates has led to more products and strategies, and, in consequence, greater liquidity and also different strikes. For example, investors often look to minimise the cost of their protection. However, depending on how costs are perceived, this could toggle demand between longer- or shorter-dated options.

Longer-dated options generally cost more upfront, but their value decays more slowly, thus making them cheaper over the long run.

Another common strategy among equity portfolio managers is call overwriting. This strategy involves an investor selling call options, which are generally out-of-themoney, on underlying holdings that they believe will have limited upside potential.

They receive a premium upfront for selling the call option and, should the underlying stock or index remain below the strike price, the investor earns the premium (as well as the gain or loss on the underlying). However,

Figure 1: average daily traded volume of Eurex Dow Jones EURO STOXX 50ÂŽ Index contracts (mm) 2.0 1.6 1.5 1.0

1.0 0.6 0.5

0

0.0

0.0

0.0

0.1

1998

1999

2000

2001

0.2

2002

Source: Eurex 1

Figure for 2008 is based on extrapolating Q1 volumes.

53

0.2

0.3

2003

2004

0.4

2005

2006

2007

2008

if the underlying ends up above the strike price, the call option will likely get exercised and the investor will have to pay away the upside above that level.

Investors can choose to overwrite at either the stock or the index level. On a notional basis, overwriting stocks generates more yield since stock options are more expensive.

However, they are also more volatile and investors thus risk missing more upside potential. Notwithstanding specific views on the index or stocks, implied correlation can be used to help measure the relative value between an index and its constituent stocks’ implied volatilities and hence their premia.

It is worth noting that, together, these flows (puts and call overwriting) contribute to the phenomenon known as the volatility skew, whereby lower strike equity options generally have higher implied volatilities than higher strike options. That is to say: demand for puts elevates their cost and hence implied volatility, while the supply of calls dampens upside implied volatilities, thus making a skew.

In addition to these fundamental applications, leveraged investors such as hedge funds employ slightly more technical strategies. Instead of using options to express directional views on shares or indexes, they use options as a means of trading implied and/or realised volatility. Indeed, the terms options and volatility are often used synonymously in this latter context.

One measure that is frequently monitored and used is implied correlation. This is the correlation implied by the implied volatilities

EUREX_EMC ADVERTORIAL JP

29/7/08

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Customer communications management: A proven solution for OTC derivatives The complexities of trading OTC derivatives and the challenges they pose for today’s financial services firms continue to evolve. While there is no single panacea for the expanding OTC derivatives marketplace, the ability to automate cumbersome and risk-prone processes sits at the top of nearly every firm’s solutions list.

But what kind of automation best suits the OTC derivatives industry? It’s one thing to purchase a new software package to remedy your pain points. It’s quite another to buy the right kind of solution that literally changes the way you conduct your business.

One smart and sophisticated solution for meeting the needs of your clients and the needs of the trading community is customer communications management.

It takes businesses beyond just fulfilling the momentary focus of solving OTC derivatives conundrums such as backlogged trade confirmations.

The ability to manage contract negotiations and confirmations online in a secure and easy-to-use environment expedites complex OTC derivatives processes with sophisticated risk-management capabilities.

Customer communications management enables acceleration of online trade negotiations, no matter how complex. In fact, the more complex, the more the solution is needed. The ability to manage contract negotiations and confirmations online in a secure and easy-to-use environment expedites complex OTC derivatives processes with sophisticated riskmanagement capabilities.

Here’s an example of what a high-quality customer communications management solution can do to move the OTC derivatives industry toward a more secure and manageable position in the marketplace: 1. Leverage industry standards—Use the familiar working environment of Microsoft® Word as the standard authoring tool.

2. Streamline processes—Manage contract creation, negotiation, approval, and execution workflow for all types of contracts and other negotiated agreements, including prime brokerage agreements, margin agreements, ISDA master agreements, and CSAs. 3. Centralize content—Employ detailed search and advanced tools for comparing all existing agreements, highlighting potential exposure, and managing risk.

4. Manage risk—Review key risk metrics, including NAV triggers, collateral events, withdrawal provisions, and other data points.

5. Track and sort—Work with an easy-to-use, realtime dashboard that tracks and sorts every outstanding agreement, enabling load balancing, tracking, and auditing.

Customer communications management can substantially boost automation, reduce risk, and expedite complex OTC derivatives processes. It’s exactly what the market needs right now.

For more information about customer communications management, including an independent research report from TABB Group, visit www.EMC.com/eurex.

EMC2, EMC, and Document Sciences are trademarks or registered trademarks of EMC Corporation. Microsoft is a registered trademark of Microsoft Corporation. © Copyright 2008 EMC Corporation. All rights reserved.

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Figure 2: Eurex Dow Jones EURO STOXX 50® Index six-month skew 30%

DJ EURO STOXX 50® Index

Skew (ATM volchg)

Dec 08

28% 26% 24% 22% 20% 18% 16% 14%

80%

85%

90%

95%

100%

105%

110%

115%

120%

Source: Barclays Capital

(although some sector options were available even earlier). This allows investors to trade dispersion between both the sector indexes and their constituents, as well as between the main indexes and the sector indexes, effectively introducing another dimension to dispersion strategies.

Another leveraged equity derivatives strategy that has grown considerably involves the use of synthetic forward transactions. A synthetic forward is essentially a combined long call and short put of the same maturity and strike. It replicates the payoff of a forward contract whereby an investor agrees to buy (or sell) an underlying at the some expiry date in the future. Consider an investor that is long the synthetic (ie, long the call and short the put). If the underlying rallies above the option’s strike price, then the investor would exercise the call option, receive the

upside from the rally and the put option would expire worthless. On the other hand, if the index ends up below the strike, the call will expire worthless and the investor will be obliged to pay the counterparty that exercises the put. This is precisely the payoff of a forward contract.

One of the main drivers behind the increase in synthetics activity is the explosive growth of the dividend swap market. Indeed, synthetics are one of the primary hedging vehicles for dividend swaps. For example, an investor who wishes to express a bullish view on the dividend(s) of a particular share (or index), could purchase the share and sell a synthetic forward. This removes the exposure to price movements, but leaves the investor holding any dividends paid between trade inception and expiration. The increasing popularity of dividends as an asset class in recent years has contributed to the strong growth in related synthetic activity.

The last equity derivatives strategy we consider here is one used by corporates.

Traditional corporate usage of equity derivatives has mostly revolved around financing, share repurchases and risk management (eg, hedging Employee Share Option Programmes (ESOPs)). However, we have also seen corporates employ derivatives in a similar manner to hedge funds in the context of mergers and acquisitions.

For example, we believe that much of the open interest in Volkswagen put options in late 2007 and early 2008 was driven by Porsche’s stake-building intentions in Volkswagen. Indeed, open interest in Volkswagen put options exploded over the

Figure 3: buying and selling flows in equity options

Convertible bonds Structured products volatility

of index options relative to constituents’ options. It can often reach levels that have not been realised historically. Indeed, the demand for protection discussed above generally applies to index options. Moreover, there is much call overwriting done via stock options, while convertible bonds provide another supply of stock volatility. These flows support the risk premium on index implied volatility and dampen the risk premium on stock volatilities, thus elevating the implied correlation.

One strategy that takes advantage of elevated implied correlations is the dispersion trade. This has become a staple trade of many leveraged investors. While implementing these trades via variance swaps is increasingly commonplace, many investors still put on dispersion trades using vanilla options, despite the extra maintenance efforts required (eg, delta hedging). The typical dispersion trade involves selling volatility (options or variance) on an index, such as the Dow Jones EURO STOXX 50® Index and buying volatility on its constituents, thereby expressing a negative view on correlation.

The Dow Jones EURO STOXX 50® Index is widely used in this strategy. Indeed, it is one of the few indexes on which there is ample options liquidity for both the index and all its constituents. Accordingly, this allows investors to minimise the volatility basis risk between the index and individual stock legs. Moreover, Eurex has listed options on all 19 of the Dow Jones EURO STOXX 50® sectors since late 2004

55

Call overwriting

Structured products Protection buying

Source: Barclays Capital

} }

Stock volatility

Index volatility

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Aaron Brask Aaron is a director and head of equity derivatives research at Barclays Capital. He joined Barclays Capital in July 2004 from JP Morgan where he was an equity derivatives strategist.

Prior to that, he worked on quantitative trading strategies for the proprietary trading desk at a Florida investment bank. Aaron completed all of his higher education at the University of Florida. He holds a BS in mathematics/statistics, an MSc in applied mathematics and a PhD in mathematical finance.

Contact Aaron.Brask@barclayscapital.com For detailed contract specifications of ISE options please refer to: www.ise.com > options exchange > products traded

Figure 4: open interest increases in Volkswagen put options Volkswagen put open interest (# contracts) 80,000

60,000

VOW GR 6 P105 VOW GR 12 P105

VOW GR 6 P140 VOW GR 12 P130

VOW GR 6 P104

VOW GR 12 P140

40,000 20,000

07-Sep-07

24-Aug-07

10-Aug-07

13-Jul-07

27-Jul-07

0 29-Jun-07

Barclays Capital Barclays Capital is the investment banking division of Barclays Bank Plc, which has an AA long-term credit rating and a balance sheet of more than GBP 1.2 trillion. Barclays Capital provides large corporate, government and institutional clients with solutions for financing and risk management purposes.

Barclays Capital provides innovative equity derivative products to clients worldwide. Its market coverage extends to all major equity indexes and top-tier single stocks. It has an increasing presence in new and emerging markets and provides access to a full range of vanilla and more complex derivative products. The bank also offers a range of hybrid products that enables clients to gain exposure within a single structure to additional asset classes.

Traditional corporate usage of equity derivatives has mostly revolved around financing, share repurchases and risk management

15-Jun-07

period as indicated by figure 4.

The basic strategy was for Porsche to acquire more shares of Volkswagen. Selling puts rewarded Porsche, as the company was effectively compensated (paid the put premium) for contractually agreeing to buy more Volkswagen shares if the share price traded below the put strikes. Corporate transactions such as these are not necessarily well-publicised, often appearing only the small-print of financial statements.

Accordingly, it is difficult to ascertain how many corporates employ such strategies and in what volume.

01-Jun-07

56

17/9/08

Source: Bloomberg

Eurex Equity Options Contract Standards Leading European and Russian equities.

Contract Sizes 10, 50, 100, 500 or 1,000 shares.

Settlement Physical delivery of 10, 50, 100, 500 or 1,000 equities of the underlying two, three or four exchange days after exercise: Contract Standard German equity options Finnish equity options

Settlement Days t+3 t+2 t+4

Minimum Price Change EUR 0.0005, EUR 0.01, CHF 0.01 or USD 0.01.

Contract Months Up to 12 months: The three nearest successive calendar months and the three following quarterly months of the March, June, September and December cycle thereafter.

Up to 24 months: The three nearest successive calendar months, the three following quarterly months of the March, June, September and December cycle thereafter, and the two following semi-annual months of the June and December cycle thereafter.

Up to 60 months: The three nearest successive calendar months, the three (for Spanish equity options nine) following quarterly months of the March, June, September and December cycle thereafter, and the four (for Spanish equity options the nearest) following semi-annual months of the June and December cycle thereafter, and the two following annual months of the December cycle thereafter.

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Reaping reward from sector futures Société Générale’s Sophie Billiard and Cyrille Drouot explore the sector futures universe and explain how these listed contracts have introduced a new range of innovative risk/reward proposals

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S

ector futures contracts offer many advantages over traditional cashbased sector index portfolios and exchange traded funds (ETFs): whereas sector cash-based index portfolios can be cumbersome to manage due to size constraints, liquidity and rebalancing factors, a derivatives-based index approach helps overcome many of these difficulties.

The dynamics of a derivatives-based portfolio are fairly simple. Instead of buying physical securities (representing the index constituents) to replicate the index, sector futures contracts are purchased and the cash balance is invested to yield a short-term interest rate.

Due to the arbitrage relationship between the futures contract and the underlying sector, the combination of futures price movement and the interest earned on the invested cash should, over time, closely track, and hopefully slightly exceed the total return of the index.

The introduction of sector-based futures, such as those listed on Eurex, has presented asset managers with new investment opportunities. Futures contracts on sectors can be inserted in the pyramid of indexing tools, allowing money managers increased investment flexibility and giving them highly correlated benchmarks against which to accurately measure their investment performance.

With each step up in the pyramid of equity products, flexibility increases. The idea of being able to move from one industry, sector, or set of investments to another has grown in popularity. As a result, the means by which one can compound gains and reduce losses has grown exponentially.

Equity sector investing refers broadly to long and/or short sector investing by asset owners, professional portfolio managers and risk managers, based on a strategic orientation to market sectors (such as the Financial or Healthcare sectors).

The launch of the STOXX® family of sector futures has provided these investors with an efficient long/short vehicle. This gives them an easy and efficient means of engaging in

59

sector rotation strategies – for instance, an investor might have shorted the Banking Industry through sector futures to avoid downward share price movements in that sector during the sub-prime crisis, and concurrently gone long commodity sector futures, to exploit the accompanying boom in commodity and energy stocks.

Figure 1 illustrates the rationale for using Dow Jones STOXX® Sector Futures contracts for long/short strategies, showing how these have out- or underperformed the core Dow Jones STOXX® 600 Index.

A consequence of the arbitrage relationship between the futures contract and the underlying sector is, of course, liquidity.

Naturally the liquidity of sector futures contracts will rely on the liquidity of the underlying basket. Market makers provide constant bids and offers on sector futures in small block sizes (under 250 futures, ie 1,250 indexes equivalent), even when individual equity markets may be closed.

There are critical differences between different sector futures. While a bank like Société Générale will quote a 13 basis point bid/offer spread on, say, the FESB (Euro Banks

Figure 1: the outperformance of the Dow Jones STOXX® Sector Indexes over the Dow Jones STOXX® 600 Index

DJS Util e Pr DJS Trv&Lsr e Pr DJS Telecom e Pr DJS Tech e Pr DJS Retail e Pr DJS PR&Ho Gd e Pr DJS Oil&Gas e Pr DJS Media e Pr DJS Insur e Pr DJS Indus Gd e Pr DJS Hea Care e Pr DJS Fin Svcs e Pr DJS Fd&Bvr e Pr DJS Cns&Mat e Pr DJS Chem e Pr DJS Bas Res e Pr DJS Banks e Pr DJS Aut&Prt e Pr -10

-5

0 Q2 2007

Q3 2007

5 Q4 2007

10 Q1 2008

15

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Figure 2: increase in turnover on Dow Jones EURO STOXX®/STOXX® 600 Sector Futures 2005-2008

SX7E) sector futures contracts for 85 futures, it would quote a 35bps spread on the Travel and Leisure Euro index for only 50 futures.

This is because of the differences between the underlying index spread and liquidity. For instance, there are 39 liquid stocks in the SX7E with a total average daily volume of EUR 5 billion; in comparison, the Travel and Leisure index is made up of nine relatively illiquid stocks with a total daily volume of less than EUR 400 million.

Another influencing factor that must be considered is the share in the index of stocks from countries that are hard to access and or have high execution fees, such as Greece or Iceland. The Travel and Leisure index, for instance, includes one Greek stock, representing 14 percent of the index. This makes these particular sector index futures that much more expensive and time-consuming to hedge than, say, the Euro Banks Index.

Thirdly, if the index is comprised of stocks from different currencies, the foreign exchange risk between the stock currency and the index currency will need to be hedged out, increasing the total spread that market makers will need to make on the futures contract. This would be the case, in, say, a pan-European sector index that included UK or Swedish stocks.

A final reason for wider or narrower spreads in different sector indexes arises from the risks assumed because of different market hours. For instance, since Norway closes at 4.20 pm, traders are no longer able to perfectly replicate the pan-Euro Energy sector after that point, since the Norwegian stocks, which account for some 6 percent of the index, are no longer trading.

Those caveats aside, sector futures can be used for a wealth of reasons. They are both a tool and an investment per se. Next we will explore some of their uses and users.

Sector futures can be used for basket trading, with the prerequisite of bid/offers being provided on the basis. The execution of the underlying basket can be best-effort, VWAP (computation of individual VWAP for each share), on the close, etc. Taking into account the level of execution of the index, the level of the futures is then calculated; the futures are crossed and allocated.

Pure sector rotation funds or pockets of absolute return funds are now dedicated to sector rotation – so called Quant Sector Rotation funds. Sector rotation is a strategy that involves some active management, but also plays into a long-term investment approach. The basic idea behind sector rotation is that the economy

operates according to cycles – some sectors will be up at certain times and down at others. Investors using this approach must identify the boom and bust cycles in the sector in which they plan to invest. During any given down periods, they will buy the sector futures and when the prices are at their peak, they will turn around and sell them.

Other managers will build their strategies on the back of a model and implement the signals via sector futures; diversified asset managers might instead continue with their fundamental approach, while implementing an investment overlay through the futures, going long or short particular sectors. Such managers will want to keep their cash investments intact, and the sector futures give them a quick and easy means of implementing sector-based tilts.

Equity portfolio managers who want to invest quickly on a theme prior to having finalised their stock-picking process, might also use them. Similarly, if the managers wish to leverage their exposure to a particular sector, they can do so through the sector futures.

Hedge fund managers who want to implement relative value plays and wish to diffuse the risk on the choice of the

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short, will use sector futures as a ‘basket’ type alternative.

Owing to the increased risks relating to mergers and acquisitions, some managers will meanwhile use sector futures as a short in long/short plays. Shorting the market globally might not provide the requested correlation of the long/short; the sector futures can give them the required correlation.

Equity derivatives traders will also use the instruments to quickly and easily hedge out their delta – indeed many equity derivatives traders players had limited access to sectors prior to the existence of the futures, making their daily delta adjustments particularly onerous.

Equity sector investing will, undoubtedly, continue to grow over the coming years.

The instruments provide a great means for gamma hedging of options and also for creating new payoffs. For instance, sector futures have facilitated the fast development of a liquid over-the-counter market for sector variance swaps, which are now used by investors and hedgers alike to trade sector volatility as an asset class. Variance swaps have proven to be a very valid hedge for stock pickers and can prove even more so when the swap is transacted on a sector basis.

Difficult to access and costly arbitrages, such as playing the dispersion and volatility

of individual stocks versus their sectors, have become popular thanks in part to the standardisation and the liquidity of the underlying sector futures contracts.

Furthermore, a new arena of semi-exotic products has recently developed, which leverages on the development of the listed markets, proving once again the powerful symbiosis between OTC and listed markets.

Two popular trades developed in the first half of 2008 are detailed below.

The Quark Option is a Société Générale innovation on plain outperformance options.

The Quark gives investors long/short exposure to two baskets of sector indexes, minimising the premium that would have to be paid if vanilla single stock options were used instead. Leverage is maximised by playing the implied correlation prices in three sectors on the long side and in three sectors on the short side.

Another example is the Palladium – an option that pays the realised dispersion achieved by five (or more) sector indexes over the average of their overall constituents. Such an option is a play on the correlation levels and the actual performance of the sectors and generates a simultaneous long volatility bias that can be useful in times of market stress.

With Palladium, one could play, for example, on the expected divergence of returns between Financials, Utilities, Energy,

61

Retail and Airlines: the higher the divergence, the higher the pay-off.

A major benefit of the Palladium structure is that investors do not need to predetermine the exact amount of over or underperformance of the relative sectors. This means that investors can take pure fundamental views, and need to put less emphasis on precise market timing. In addition, the Palladium structure can embed a feature that links it to the maximum dispersion level reached during the period (using the socalled ‘lock-in’ mechanism). This will reduce the risk of precisely timing market entry as well as exit.

Thanks to the deep liquidity provided by the largest market makers in sector futures, such semi-exotic transactions have quickly become very liquid with tight bid/offer spreads. They are already a mainstay of OTC offerings, being very popular with long/short investors such as hedge funds and 130/30 funds, stock pickers and volatility arbitragers alike. In our minds, there is no doubt that sector futures will continue to provide a new world of innovative risk/reward proposals.

Société Générale Corporate & Investment Banking (SG CIB) SG CIB is the investment banking arm of Société Générale Group. It is present in 45 countries and specialises in Euro capital markets, derivatives and structured finance.

Table 1: equity linked sector swaps and sector futures compared

Equity linked swaps

Futures

Type

Over-the-counter contract. The investor has to be able to trade OTC derivatives instruments, and will first need to negotiate a master agreement (an ISDA for example). He will need to get credit approval and will need to respond to or make margin calls as necessary. The trade will need to be unwound with the original counterpart.

Listed on an exchange. The investor has to have permission to trade the listed instruments and will need a clearing account. Margin calls will be made on a systematic basis, and the investor will have no bilateral credit exposure. Total flexibility at the point of unwind, when the future can be sold (or bought back) on the exchange.

Valuation

Provided by the counterparty.

Published by the exchange.

Liquidity

The liquidity will depend on the liquidity in the index’s underlying assets.

The liquidity will depend on the liquidity in the index’s underlying assets.

Pricing

Pay as you go for standard ELS for both repo and dividends.

The basis prices the dividends until expiry as well as the repo when shorting the future. The repo cost is lost if the future is bought back prior to expiry.

Maturity

Full flexibility – this can be tailored to the investor’s requirements.

The sector futures’ maturity is set according to the three next quarterly expiries.

Operational

More complex to put in place, but valuable for long maturities and primary and secondary trades in large sizes.

A standardised product that is fully transparent and very easy to trade.

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The group’s 12,000 professionals assist issuer clients (corporates, financial institutions, public sector, investment funds) with their financing or investment projects in a spirit of long-term partnership. Drawing on its strong expertise and tradition for innovation, SG CIB has developed a wide range of derivative products to help clients optimise hedging of the various types of risks related to market operations. The SG CIB teams are constantly looking to devise and implement appropriate high-performance, integrated solutions that combine their expertise in the three areas of excellence in which the bank has developed a leadership position and cutting-edge know-how in recent years. SG CIB is widely recognised for its world-leading franchise in equity derivatives.

Sophie Billiard Sophie joined Société Générale equity derivatives department in 2006 as flow products salesperson focusing on French institutional investors. She started her career 14 years ago at Banque Indosuez in the foreign exchange markets, but quickly moved on to establish herself as a specialist in equity derivatives flow sales. Prior to joining SG, she previously covered various European markets at Morgan Stanley and ING in London.

Cyrille Drouot Cyrille joined Société Générale equity derivatives department in 1999 as an engineer for structured products. Cyrille is now deputy head of European exotic flow sales and is based in Paris. Since early 2007, he has been in charge of developing exotic flow products for asset managers, hedge funds and proprietary traders.

Contacts sophie.billiard@sgcib.com cyrille.drouot@sgcib.com

Thanks to the deep liquidity provided by the largest market makers in sector futures, such semi-exotic transactions have quickly become very liquid with tight bid/offer spreads

Eurex Sector Derivatives Price quotation and minimum price change Contract

Contract value per index point of the underlying

DJ EURO STOXX® Sector Futures DJ STOXX® 600 Sector Futures DJ EURO STOXX® Sector Options DJ STOXX® 600 Sector Options DJ Global Titans 50 IndexSM Futures Futures on DJ Banks, Insurance, Oil & Gas, Telecommunications and Utilities Titans 30 IndexesSM

EUR 50 EUR 50 EUR 50 EUR 50 EUR 100 / USD 100 USD 100

Minimum price change

Points 0.1 0.1 0.1 0.1 0.1 0.1

Value EUR 5 EUR 5 EUR 5 EUR 5 EUR 10 / USD 10 USD 10

With the launch of futures and options on the Dow Jones EURO STOXX® Real Estate and Dow Jones STOXX® 600 Real Estate indexes in September 2008, Eurex covers all 19 supersectors.

For detailed contract specifications, please refer to www.eurexchange.com > Trading > Products > Equity Index Derivatives

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Deriving extra value from dividends Byron Baldwin explains how banks and investors can use the Eurex Dow Jones EURO STOXX 50速 Index Dividend Futures

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O

n 30 June, 2008 Eurex launched the Dow Jones EURO STOXX 50® Index Dividend Future.

It is the first exchange-traded derivatives contract that focuses solely on the dividend element of a widely used and traded equity index, the Dow Jones EURO STOXX 50® Index. The new contract allows investors and traders alike to take a view on the gross cumulative cash dividends that are announced and paid by the individual constituents of the Dow Jones EURO STOXX 50® Index during an annual period.

The contract is an exchange-traded derivative equivalent of an over-the-counter (OTC) index dividend swap, and offers a multitude of applications for the institutional investor.

In addition, because the futures contract is cleared through Eurex’s central counterparty, Eurex Clearing AG, it has the benefit of substantially reduced counterparty risk.

The index dividend swap market initially grew from banks’ needs to manage the dividend exposure resulting from their structured product activity, and hedge funds’ appetite to take on this exposure. Today, it is estimated that daily dividend swap turnover is almost EUR 1 billion.1 An index dividend swap is an OTC derivative contract that enables investors to take a view on the cumulative dividends that will be paid by the constituents of an index in a pre-determined time period. The dividend period is usually one year and in Europe it typically starts and ends on the third Friday in December, when index futures contracts expire. The Dow Jones EURO STOXX 50® Index is the most actively traded index in Europe and the dividend swap on it constitutes the majority of trades in the OTC market.

On 14 March, 2008 the quote for the December 2008 Dow Jones EURO STOXX 50® Index dividend swap was 155.9 index points (this covers the period from December 2007

to December 2008). In this example, the dividend buyer commits to pay the index points multiplied by the exposure per point (ie, 155.9 x EUR 100,000), while the dividend seller commits to pay the realised dividend at maturity, multiplied by the exposure per point (ie, realised dividend x EUR 100,000).

The attraction of dividends to institutional investors lies in their low correlation to traditional investment asset classes, such as bonds and equities. A study2 was carried out on the relationship between (daily) changes in the Dow Jones EURO STOXX 50® Index December 2008 dividend swap and the (daily) change in: • Three-month EURIBOR Futures • Dow Jones EURO STOXX 50® Index • Generic ten-year European government bond yield for the period 16 March, 2006 to 14 March, 2008 The results showed that there would seem to be little relationship between dividends in terms of Dow Jones EURO STOXX 50® Index dividend swaps and EURIBOR, European equities or bonds. The R2 or ‘goodness of fit’ statistic was 0.01 in all three cases, showing that little correlation existed between the variables under investigation. The benefits of dividends as a diversified asset can be seen by comparing the returns of a fixed income

portfolio, replicated by a holding in Eurex Euro-Buxl® Futures, and a portfolio which has an 80 percent allocation to the EuroBuxl® Future and a 20 percent allocation to Dow Jones EURO STOXX 50® December 2008 dividend swaps. (The combined 80/20 percent portfolio is rebalanced weekly; both portfolios are indexed at 100 on 4 January, 2007). The results are shown in figure 1.

Relative value – implied dividend yield spread trading The Dow Jones EURO STOXX® Dividend Index Futures contract offers a very cheap and leveraged way for trading relative value spread or barbell positions in the composite dividends of the Dow Jones EURO STOXX 50® Index. The spread margin requirement for the Dow Jones EURO STOXX 50® Index Dividend Future is 25 percent of the initial margin requirement. As the futures price quotation is in terms of index points, implied dividend yields can be easily calculated. For example, on 14 March, 2008, December 2009 Dow Jones EURO STOXX 50® Index dividend swaps were quoted at 146.1 index points with the Dow Jones EURO STOXX 50® Index at 3566.59, which generated an implied dividend yield of 4.096 percent. The introduction of an exchange-traded index dividend future

Figure 1: the benefits of dividends as a diversified asset 101.00 99.00

97.00

95.00

93.00

91.00

89.00

87.00 2 January 2007

2 March 2007

2 May 2007

100% Eurex-Buxl® Future

2 July 2007

2 September 2007

2 November 2007

2 January 2008

2 March 2008

80% Eurex-Buxl® Future/20% DJ EURO STOXX 50® Index dividend swap

Data source: Barclays Capital and Eurex

See Financial Times, 21 April, 2008.

See B. Baldwin, Eurex Dow Jones EURO STOXX 50® Index Dividend Futures – Pricing & Applications for the Institutional Investor.

1.

2.

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will certainly facilitate trading in dividend flattening and steepening spread trades among institutional investors and hedge funds alike.

Portfolio overlay The introduction of the Dow Jones EURO STOXX 50® Index Dividend Futures contract enables investors to buy and sell European dividends on exchange for the first time, increasing fund managers’ ability to effect changes in portfolio asset allocation efficiently and quickly while leaving their existing portfolios intact3. For example, consider a fund manager who has a EUR 100 million European medium-term maturity government bond portfolio and who has decided to switch 20 percent of his investment to European dividends. The European bond portfolio has a duration of 7.5 years, similar to the duration of the Eurex Euro-Bund Futures cheapest-todeliver bond, DBR 4.25 percent July 2017, of 7.14 years. The BPV (basis point value, ie, value of a 0.01 change in yield) of the fund managers’ bond portfolio is therefore EUR 75,0004. The BPV of the Euro-Bund Future is 0.082145 or EUR 82.14 in monetary terms, ie, the value of a 0.01 in price terms for a EuroBund Future is EUR 10.

The steps the manager would take implementing a portfolio overlay strategy to switch part of his investment in European government bonds to European dividends are as follows: 1. Determine the number of Euro-Bund Futures to sell: (EUR 75,000 / EUR 82.14) X 0.20 ~ 183 Euro-Bund Futures contracts) 2. Determine the Euro-Bund Futures / Dow Jones EURO STOXX 50® Index dividend ratio: One method he could use is to ratio the monetary value of a 0.01 change in yield of Euro-Bund Future to the monetary value of a 0.01 change in implied dividend yield in the Dow Jones EURO STOXX 50® Index Dividend Future.

The monetary value of a 0.01 change in yield of the Euro-Bund Future is EUR 82.14.

With the December 2008 Dow Jones EURO STOXX 50® Index dividend swap at 155.9

Figure 2: portfolio overlay with Dow Jones EURO STOXX 50® Index Dividend Futures

Original portfolio

Synthetic portfolio

European fixed income portfolio

Buy Eurex DJ EURO STOXX 50® Index Dividend Future Sell Eurex Euro-Bund Future

European fixed income exposure

Dividend exposure

Portfolio overlay

implying an implied dividend yield of 4.37 percent (ie, Dow Jones EURO STOXX 50® Index at 3566.59) a 0.01 change in dividend yield would imply a price change of 0.31 or EUR 31.0 in monetary value.

This would therefore imply a ratio of 1 Euro-Bund Futures: 2.65 Dow Jones EURO STOXX 50® Index Dividend Futures.

retail investors upside exposure to the index, together with a guarantee that the initial sum invested will be protected. His return would exclude any dividend payment. The product structurer will therefore have a long exposure to dividends. This exposure can be hedged using Dow Jones EURO STOXX 50® Index Dividend Futures.

3. Calculate the number of Dow Jones EURO STOXX 50® Index Dividend Futures to buy:

Maximising exposure to share price appreciation – dividend stripping In this strategy, a portfolio manager would synthetically sell the projected dividend stream of his European equity holding by selling Dow Jones EURO STOXX 50® Index Dividend Futures. He would use the proceeds to buy more cash equities and then sell more Dow Jones EURO STOXX 50® Index Dividend Futures on the anticipated dividend stream on the equities he has just purchased. So the procedure would continue, until the dividend element is completely eliminated. This exercise would ‘strip out’ the dividend income stream element of the manager’s equity investment, thereby maximising his exposure to share price appreciation.

Number of contracts to buy = (183) X (2.65) ~ 485 Dow Jones EURO STOXX 50® Index Dividend Futures.

The fund manager would thus sell 183 Euro-Bund Futures and buy 485 Dow Jones EURO STOXX 50® Index Dividend Futures to synthetically switch 20 percent of his European government bond investment to a European dividend exposure, while leaving his existing portfolio intact. Once the manager believes the outperformance of European dividends to European government bonds has run its course, he would unwind his futures portfolio overlay spread position and return to being fully invested in European government bonds.

Hedging the dividend element of European equity structured products Structured products based on the Dow Jones EURO STOXX 50® Index will normally give

Hedging/trading European dividend exposure A European equity fund manager, worried that dividends will fall, can sell Dow Jones EURO STOXX 50® Index Dividend Futures to hedge his exposure. Convertible bond portfolio managers are natural users of dividend swaps to hedge their dividend

See B. Baldwin, ‘Derivatives: Increasing the Efficiency of Fund Management’, Pensions World, December, 2004 for applications of exchange-traded derivatives in fund management.

BPV of a bond portfolio is: Duration x 0.0001 x Investment.

5 BPV of a Euro-Bund Future is BPVctd / PFctd where BPVctd is the basis point value of the cheapest to deliver bond and PFctd is the price factor of the cheapest to deliver bond.

3 4

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The benefits of the new index dividend contracts are enhanced by the Eurex OTC Block Trade facility exposure. Option market makers in Dow Jones EURO STOXX 50® Index Options can also use Dow Jones EURO STOXX 50® Index Dividend Futures to hedge their embedded dividend exposure. Similarly, the Dow Jones EURO STOXX 50® Index Dividend Futures contracts allow investors to engage in leveraged trading of European dividends on exchange, without their needing to take a position in the underlying shares. The contracts also give investors the ability to trade European dividends against other European asset classes using Eurex benchmark equity and fixed income products.

The benefits of the new index dividend contracts are enhanced by the Eurex OTC Block Trade facility (BTF), which links the OTC and exchange-traded dividend swaps markets together.

The Eurex OTC BTF has been extended to Dow Jones EURO STOXX 50® Index Dividend Futures, offering maximum liquidity and trading flexibility to fund managers initiating portfolio overlay strategies across European asset classes. The BTF

allows market participants, whether trading for their own account or on behalf of customers, to enter into off-exchange transactions in Eurex futures and options contracts and clear the trades through Eurex Clearing. The minimum block trade size for Dow Jones EURO STOXX 50® Index Dividend Futures is one contract .

The introduction of the Dow Jones EURO STOXX 50® Index Dividend Futures contract further extends the options and possibilities open to institutional investors for trading European dividends as an asset class. It also increases their scope for generating alpha by facilitating relative value dividend term structure transactions and trading dividends against other asset classes. The fact that the minimum size of block trades in Dow Jones EURO STOXX 50® Index Dividend Futures has been set at just one contract, also gives maximum flexibility to traditional fund managers and hedge fund managers, allowing them to trade off-exchange, while benefiting from the use of Eurex Clearing, which substantially reduces their counterparty risk.

Eurex Dow Jones EURO STOXX 50® Index Dividend Futures (FEXD) Contract Standard Contract Dow Jones EURO STOXX 50® Index Dividend Futures

Product ID FEXD

Underlying Dow Jones EURO STOXX 50® Index Dividends (Dow Jones EURO STOXX 50® DVP)

Byron Baldwin Byron is a member of the institutional investor business development team at Eurex. Byron has more than 25 years of experience in exchange-traded derivatives, working with hedge funds, central banks, fund management companies and corporations. He has written a number of articles on the use of derivatives in fund management and has spoken extensively at conferences on the use of derivatives in fund management. Byron read monetary economics at the London School of Economics for his BSc. (Econ.) degree and finance for his MSc. degree at the University of Leicester Management Centre.

Contact Byron.Baldwin@eurexchange.com References Financial Analysts Journal, Volume 64, ‘The Market for Dividends and Related Investment Strategies’.

Barclays Capital, ‘Index Dividend Swaps.

Where from Here?’ August 2005, ‘Dividend Swap Primer’, October 2004 and ‘Global Speculations: Dividend Delights’, September 2005.

Contract Value EUR 100 per index dividend point of the underlying.

Risk, ‘Uncertain Dividends’, October 2007 and ‘Dividend option market tipped for growth’, April 2008.

Settlement Cash settlement, payable on the first exchange day following the Final Settlement Day.

Goldman Sachs, ‘Dividend Focus. Turning Cash into Value’, September 2006.

Price Quotation and Minimum Price Change The Price Quotation is in points with one decimal place. The Minimum Price Change is 0.1 points, equivalent to a value of EUR 10.

Financial Times, ‘Dividends – the accidental asset class’, July 2007; ‘Companies International: Trading Strategies’, July 2007; ‘Lex Column: Dividend Swaps’, April 2008.

Contract Months Up to 84 months: The seven nearest successive annual months of the December cycle.

JP Morgan, ‘European Wholesale & IBs. Equity Derivatives – difficult environment ahead’, May 2008.

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69

On the right track – exchange traded funds derivatives UniCredit’s Paolo Giulianini and Enrico Camerini explains how you can exploit asset allocation opportunities through exchange traded funds (ETF) and ETF futures and options

S

ince the first exchange traded fund (ETF) was launched in the US in 1993, ETFs have opened a vast new panorama of investment opportunities, much as the original index futures did a decade or so earlier.

ETFs have since outpaced index futures both in terms of the sheer number of listed assets (there are now 10 ETFs listed for every one futures contract), and in terms of the asset classes covered.

Essentially, ETFs are traditional, mutual open-end index funds that are listed and traded on exchanges like stocks or index futures. ETFs, however, are not derivatives; they have no fixed maturity and do not need a specific account (margin) to be set up for trading.

ETFs allow investors to gain broad

exposure to entire stock markets, to emerging markets, sectors, styles, or to fixed income and commodity indexes.

They are tradable on a real-time basis and at a lower cost than many other forms of investing. Furthermore, and unlike traditional funds, they are fully transparent, as managers provide portfolio composition data to the market on a daily basis.

ETFs have many investment applications.

As a combination of an index fund and a stock, an ETF can be analysed from either

standpoint. Like a traditional mutual fund, the most common objective of an ETF is to track or replicate a particular index (with minimum tracking error) through a basket of securities.

Although ETFs are constructed similarly to mutual funds, investors can deal in them just as they would normally buy the shares of any publicly traded company, buying or selling ETF shares through a broker or in a brokerage account.

Following the success of the ETF products themselves, exchanges like Eurex have rolled out futures and options contracts on ETFs. Investors are now using the ETF cash instruments along with these derivatives, often with a buy write strategy, protective put strategy or a stop-loss/start–gain strategy.

The most common application is for adopting

The most common objective of an ETF is to track or replicate a particular index through a basket of securities

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a market neutral approach – going long a basket of ETF futures and shorting a blue chip index future.

We will now explore how we can achieve a low-volatility excess return with respect to the Dow Jones EURO STOXX 50® Index (the most widely-followed European blue chip index due to the tremendous liquidity of the Eurex-listed futures and options contracts on the index). We do this using portfolio optimisation to deliver passive and low-volatility alpha return in the context of a diversified Eurozone equity allocation.

Let us consider that an investor wants to find the best possible allocation between the various European equity indexes that form the core of his investment portfolio.

Following the theory described above, we construct portfolios by performing minimum variance optimisation.

We minimise the total portfolio risk, solving the following:

The opportunity set used to construct the ETF portfolio is made up of four indexes; we select two for the size factor: the Dow Jones EURO STOXX® Small Index and the Dow Jones EURO STOXX® MidCap Index, and two for the pure style factor: the Dow Jones EURO STOXX® Large Value Index and the Dow Jones EURO STOXX® Large Growth Index (the latter two being style indexes constructed from the Dow Jones EURO STOXX® Index). Similar results could be achieved using MSCI EMU Small and Mid Cap and the MSCI EMU Value and Growth.

We perform the optimisation without imposing constraints on the weights of the style indexes. Out-of-sample comparison is performed with the Dow Jones EURO STOXX 50® Index as the reference.

Successive optimisations are performed using three years of weekly data with sixmonth rolling windows. The data covers the period from July 1997 to May 2008.

The initial portfolio is based on data from July 1997 to June 2000. This portfolio is rebalanced six months later by performing a new optimisation using data from January 1998 to December 2000. We continue this process every six months. The latest rebalancing is realised using data from the period January 2004 to December 2007.

Our examples were performed using index data, but the strategy is easily transposable to the ETFs and index futures based on these indexes. Indeed, the ETFs and futures would have the crucial advantage of being easily tradable, enabling cost efficient portfolio rebalancing whenever necessary.

The results of this strategy appear in figure 1 and figure 2: We can see that optimised portfolios display better results than the Dow Jones EURO STOXX 50® Index through the whole period. The greatest improvement in terms of performance is obtained during the upside market period.

Figure 1 T

min : σ p = w Σw

Average return

Final wealth (w0 = 100)

Max drawdown

Volatility (annualised)

Sharpe ratio (risk free = 2%)

subject to the following constraints:

Port. min. risk

5.5%

153.08

-49.8%

15.3%

0.23

w≥0

DJ EURO STOXX 50® Index

-1.6%

88.04%

-61.2%

20.0%

-0.18%

=0

18 0

Outperformance

Optimal Allocation

DJ EURO STOXX 50® Index

16 0 14 0 12 0 10 0 80 60 40 20

30/03/2008

30/12/2007

30/09/2007

30/03/2007

30/06/2007

30/12/2006

30/09/2006

30/03/2006

30/06/2006

30/12/2005

30/09/2005

30/03/2005

30/06/2005

30/12/2004

30/09/2004

30/03/2004

30/06/2004

30/12/2003

30/09/2003

30/03/2003

30/06/2003

30/12/2002

30/09/2002

30/03/2002

30/06/2002

30/12/2001

0

30/09/2001

Σ is the variance - covariance matrix

Wealth 2 0 0 (EUR)

30/03/2001

w is the portfolio weight' s vector

30/06/2001

σ p is the portfolio risk

Figure 2

30/12/2000

where :

30/06/2000

i

i

30/09/2000

∑w

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The statistics table shows that the average return of the Dow Jones EURO STOXX® Index for the whole period (July 2000 to May 2008) was negative (-1.6 percent), while the average return of the optimised portfolio (Port. min. risk) was positive (+5.5 percent).

What could be seen as a few percentage points difference in the yearly returns in fact generates a wide gap in the final value.

The portfolio invested in the Dow Jones EURO STOXX 50® Index is worth EUR 88 at the end of May 2008. At the same time, the minimum risk portfolio has a value of EUR 153 – almost two times the benchmark portfolio’s value. The volatility of the minimum risk portfolio (15.3 percent) was also lower than that of the Dow Jones EURO STOXX 50® Index (20 percent), meaning that the minimum risk optimisation allows higher returns with lower risks compared to the Dow Jones EURO STOXX 50® Index.

These results were strengthened by the sharpe ratio computed and displayed in the last column of figure 1. The sharpe ratio measures the excess return (the return above the risk free rate) per unit of risk (portfolio standard deviation) of the investment. The maximum drawdown statistic measures the maximum cumulative loss from a peak to the following trough and shows how sustained one’s losses can be.

What could be seen as a few percentage points difference in the yearly returns in fact generates a wide gap in the final value

The Dow Jones EURO STOXX 50® Index maximum drawdown was -61.2 percent during the observation period, while the maximum drawdown on the minimum risk portfolio was -49.8 percent. The grey area in figure 2 – the ‘outperformance’ – shows the excess return generated by the minimum variance allocation over the Dow Jones EURO STOXX 50® Index. This excess return had very low correlation with the Dow Jones EURO STOXX 50® Index during the bear market that

Figure 3

100 % 90 %

DJ EURO STOXX® TM Large Growth

80 % 70 %

DJ EURO STOXX® TM Large value

60 % 50 %

DJ EURO STOXX® Mid

40 % 30 %

DJ EURO STOXX® Small

20 % 10 %

Oct 07

Oct 06

Feb 07 Jun 07

Oct 05

Feb 06 Jun 06

Oct 04

Feb 05 Jun 05

Jun 04

Oct 03

Feb 04

Jun 03

Oct 02

Feb 03

Oct 01

Feb 02 Jun 02

Jun 01

Oct 00

Feb 01

0%

Jun 00

71

prevailed in the first two years of the holding period. The 12-month rolling correlation between the excess return and the Dow Jones EURO STOXX 50® Index ranged in the -0.2/-0.8 area from June 2001 to June 2003.

The same correlation became positive over the bull market that started in March 2003, varying inside the +0.6/+0.9 range from November 2003 to June 2007. In the following months, correlation was not stable, ranging from 0 to +0.8.

In figure 3 we can see the evolution of portfolio allocation throughout the period. It shows that the portfolio was 100 percent invested in the Dow Jones EURO STOXX® Small Index during a great part of the period and that it was only at the end of the holding period that the main portfolio allocation shifted toward the Dow Jones EURO STOXX® TM Large Growth.

The Dow Jones EURO STOXX® Small Index represents small cap stocks with a variable number of components across the Eurozone.

The Dow Jones EURO STOXX® TMI Large Index represents large cap stocks with a variable number of components across the Eurozone. The composition of the indexes is reviewed quarterly in March, June, September and December. The indexes are weighted by free float market capitalisation. The free float weights are reviewed quarterly.

It is possible to build up a portable alpha strategy by buying a long position on the ETFs mirroring the appropriate index and a

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Figure 4 ETF name

Bloomberg ticker

ISIN code

Currency

Management company

Management fee annual (%)

iShares DJ EURO STOXX® Mid Cap

IQQM GY

DE000A0DPMX7

EUR

Barclays Global Investors Ireland Ltd

0.40

XMTCH MSCI EMU Mid Cap

XMEUM SW

LU0312694234

EUR

Credit Suisse Fund Management S.A.

0.40

iShares DJ EURO STOXX® Small Cap IQQS GY

DE000A0DPMZ2

EUR

Barclays Global Investors Ireland Ltd

0.40

Lyxor MSCI EMU Small Cap

KLC GY

FR0010168773

EUR

Lyxor International Asset Management

0.40

iShares DJ EURO STOXX® Growth

IQQG GY

DE000A0HG3L1

EUR

Barclays Global Investors Ireland Ltd

0.40

Lyxor MSCI EMU Growth

GWT GY

FR0010168565

EUR

Lyxor International Asset Management

0.40

iShares DJ EURO STOXX® Value

IQQV GY

DE000A0HG2N9

EUR

Barclays Global Investors Ireland Ltd

0.40

Lyxor MSCI EMU Value

VAL GY

FR0010168781

EUR

Lyxor International Asset Management

0.40

short position on the Dow Jones EURO STOXX 50® Futures contract listed on Eurex.

The futures contract size is EUR 10 per index point; it has a quarterly expiration schedule and an impressive liquidity with a daily volume of more than 1 million contracts on average.

This sort of exposure (long ETFs and short futures) would allow investors to gain the excess return we called ‘outperformance’, shown in figure 3.

A selection of the ETFs that could be used to implement the long position on the style indexes discussed is presented in figure 4.

UniCredit Group – Markets & Investment Banking UniCredit Group is ranked among the top three European banking groups in terms of market capitalisation. With more than 180,000 employees servicing 40 million customers in 23 core markets, UniCredit Group has the largest network among its peers. Its markets & investment banking division offers fully-fledged investment banking services in UniCredit Group's core countries and is supported by an international platform offering products such as structured derivatives, fixed income, currencies, M&A in core markets, acquisition & leveraged finance, project & commodity finance, equities, principal investments and research. The structured equity derivatives business consistently achieves numerous top ratings in Germany and is also the leader in the Italian portfolio insurance market as well as in Italian OTC interest rate and equity derivatives. The linear derivatives function covers the market making activity on ETFs and futures listed on the main European markets.

The futures contract size is EUR 10 per index point; it has a quarterly expiration schedule and an impressive liquidity with a daily volume of more than 1 million contracts on average

Paolo Giulianini Paolo is director, head of ETF trading and advisory within markets and investment banking at UniCredit Group. He runs the successful ETF team based in London, Munich and Milan, which covers all issuers, all asset classes and all exchanges in the ETF market.

Paolo spent 14 years as head of delta-1 products at Banca IMI, responsible for building the activity into one of the leading market makers for ETFs in Germany, France and Italy. He holds a BA degree in financial markets from Bocconi University in Milan.

Enrico Camerini Enrico is UniCredit HVB’s Italian head of ETF

sales. For the past five years he has been developing the ETF sales activity with Italian institutional investors, which provides indepth advisory and trading on ETFs to mutual and pension funds, wealth managers, foundations and insurance companies. Before joining the investment banking sector, Enrico was the head of pension funds portfolio management in one of the biggest asset management companies in Italy. Enrico holds a degree in economic and banking science from the University of Siena.

Contacts Paolo.Giulianini@unicreditgroup.co.uk Enrico.Camerini@unicreditgroup.co.uk

EUREX_ICUBIC JP

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Eurex – working with the over-the-counter markets

The over-the-counter (OTC) and listed derivatives markets have long thrived side by side. While the listed markets provide a safe, secure, transparent, standardised and regulated means of managing risk, the OTC markets have offered a means of trading more esoteric or customised risks. Natasha de TerĂĄn explores how Eurex is working together with the OTC market

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T

raditionally exchanges have supported the OTC markets by offering listed alternatives that have often replaced or supported OTC alternatives.

Shifting large volumes of derivative activity into an exchange environment dramatically reduces operational and credit risk, alleviates back and middle office functions, eases the risk management oversight process and provides for total pricing transparency.

The centralisation of trading activity coalesces liquidity, reducing friction costs and easing the price discovery process. However, exchanges have not only supported OTC activity by designing listed alternatives to OTC derivatives – they have also offered many of the core benefits of exchange trading to the OTC markets in the form of OTC-cleared products.

Introducing a central counterparty mechanism to OTC trading alleviates much of the aforementioned risk, while allowing trading activity to continue as it would normally in the bilateral market environment.

Eurex first started offering OTC facilities to the OTC equity derivatives markets back in 1997, when it introduced a Block Trade facility for equity and equity index options.

Since then it has expanded its OTC capabilities substantially, offering a Flexible Options facility in 2005, and extending this to futures contracts in 2007.

OTC Block Trades The Block Trade facility allows standardised Eurex products that have been traded offexchange to be entered in the Eurex® system in order to benefit from the advantages of standardised clearing and trade processing.

Block Auction Requests The Block Auction Request facility extends Eurex wholesale services from the Block Trade facility described above, to incorporate pricefinding mechanisms. Participants enter requests for large Block Trade transactions into the Eurex® system, triggering an anonymous auction process, through which interested market participants can enter quotes. Indicative auction bid/ask prices are evaluated and made visible to both sides. If the originator accepts the auction price, the trade is concluded and the system generates a multilateral Block Trade, automatically triggering the ensuing clearing procedures.

OTC Flexible Contracts The OTC Flexible Contracts facility supports OTC trading, clearing and settlement of tailormade options and futures contracts. It allows investors to customise their trades to meet their individual needs, while still benefiting from the efficiency and security of standardised clearing and settlement processes.

All equity and equity index options and futures (as well as fixed-income options) are available for trading through the facility.

OTC customers can design Flexible Options by selecting the exercise price, the expiration

75

date, the exercise style (American or European), the settlement type (cash or physical settlement). In addition, qualifying trades can be partially closed-out and partially exercised. Similarly, OTC customers can design Flexible Futures by selecting the maturity and the settlement type and features (as detailed above for options).

OTC Vola Trades Catering to the growing amount of pure volatility trading, Eurex Clearing now supports the clearing and settlement of OTC Vola Trades.

The OTC Vola Trade facility allows authorised Eurex members to clear options and futures positions resulting from OTC Vola Trades through Eurex Clearing. They are administered like normal exchange positions

by Eurex Clearing and may be closed through the regular market.

OTC Exchange for Physicals (EFP) Eurex supports the clearing and settlement of OTC EFP trades. This facility allows Eurex members to enter transactions that are concluded off-exchange – in respect of futures contracts that are tradable on the exchange – and which are then admitted to the OTC EFP trade facility for clearing purposes.

The EFPs – equity index futures (EFPI) – is particularly relevant to traders using equity index contracts. It allows members to organise and execute transactions that involve a combination of a specified cash market trade (equities basket), traded on-

Eurex Clearing now supports the clearing and settlement of OTC Vola Trades

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Figure 1: Multilateral Trade Registration facility

New Multilateral Trade Registration facility – key features Eurex further enhanced its OTC entry facilities by introducing the Multilateral Trade Registration functionality on 1 July, 2008.

It allows the entry of Block Trades with one buyer or seller and several counterparties – instead of entering separate bilateral Block Trades.

The broker entering the trade does not necessarily have to be a counterparty to the trade itself, but may enter each side of the trade directly on behalf of the beneficiary owners.

Multilateral trade

Broker Liquidity provided by member A

Initial order/ liquidity demand

Liquidity provided by member B Liquidity provided by member C

exchange or OTC, and a futures trade. The number of traded futures contracts must be in a specific relation to the nominal value of the equities basket.

Multilateral Trade Registration As from 1 July, 2008, Eurex Clearing has also offered a Multilateral Trade Registration (MTR) facility (see figure1) and a new dealbased pricing structure for equity options.

The MTR allows brokers to enter block trades with one buyer or seller and multiple counterparties instead of entering separate bilateral block trades. Regardless of the number of partial executions, Eurex Clearing charges only one price per deal.

Additionally, and in order to encourage volume growth from the OTC market, Eurex Clearing has reduced fee caps on large OTC Block Trades, covering both single stock futures and equity options.

The new functionalities and pricing should make it even more attractive for bilateral OTC transactions to benefit from central risk management and straight-through processing via Eurex Clearing.

The need for a CCP Eurex’s OTC facilities have, in common with other exchanges, been widely used for some time, but demand has increased notably in recent years because operational shortfalls

The credit crunch led to a new awareness of counterparty credit risk

have blighted the OTC markets.

As OTC trade volumes mounted, dealers and investors active in the markets found themselves buried under mounds of paperwork. Few had systems capable of booking, tracking, affirming and confirming trades – and even fewer had systems that could support the trades throughout their lifecycles. The result was that some trades remained unconfirmed and undocumented; collateral and margin payments were not made; and due cash flows arrived late – if at all. The dealers strove to build and improve the supporting mechanisms, but operational, market and credit risks continued to run rampant.

Where possible, exchanges like Eurex have looked to introduce more exchange traded OTC alternatives – such as its Vola Futures – and to widen their clearing facilities. These measures have helped improve OTC operations substantially, but it was not until mid-2007 that the benefits of centralised clearing were thrown dramatically into stark relief.

As the credit crunch began to bite, resulting in a widely gapping market and scant liquidity, investors and banks with OTC positions suddenly faced significant mark-tomarket losses. Worse still, for those assets in which liquidity had evaporated altogether, it was not always possible for them to mark their positions at all.

Furthermore, the credit crunch led to a substantial re-rating of financial market counterparties and a new awareness of counterparty credit risk. Most OTC positions were collateralised, but even this was not sufficient to allay the fears of many investors who suddenly woke up to the threat of a major financial market counterparty going into default.

Other investors found themselves subject to sudden and arbitrary margin calls from their OTC counterparts – calls that, in some cases, forced some of the more highly

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leveraged investors to close down their funds.

How this affected the derivatives markets is all too clear: in the second half of 2007 the pace of growth in the global OTC markets slowed substantially. Conversely, growth in the listed derivatives markets continued unabated. End of year statistics from the Bank for International Settlements, for instance, showed that OTC market growth slowed from 24 percent in the first half, to just 15 percent in the second half of the year. In the equity derivatives segment, the OTC market even went into reverse, with the notional amount of risk outstanding, declining from the USD 8.6 trillion recorded in June 2007, to USD 8.5 trillion by year-end.

The exchange traded segment meanwhile saw a year-on-year increase of 30 percent in futures turnover in the second half of 2007, and a near 50 percent in options volumes. In the equity index segment, futures turnover near doubled in 2007, while options volumes rose by 53 percent.

Regulatory impetus By mid-2008, regulators had become more vocal in their support for the greater use of exchange mechanisms and central counterparty clearing. In the Financial Times, Timothy Geithner, president and chief executive of the Federal Reserve Bank of New York, wrote: “We have to improve the capacity of the financial infrastructure to withstand default by a big institution. This will require taking some of the risk out of secured funding markets, increasing resources held against default in the centralised clearing house, and encouraging more standardisation, automation and central clearing in the derivatives markets.”

Geithner said that, in addition, regulatory policy would have to encourage higher levels of margin and collateral against derivatives to better cover the risk of market illiquidity. In other words, collateral requirements will need to rise in the derivatives markets.

Wholesale trading facilities at Eurex: development of trading volume (in million contracts, single counted)

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In the listed markets, higher margin thresholds should not be such a concern to cash collateral-constrained investors, since the multilateral netting and cross-product margining facilities significantly reduce the amount of collateral necessary. In the OTC markets, conversely, the bilateral nature of credit exposures means there is significantly less ability to offset positions that would normally net each other out.

Both OTC and listed derivatives will almost certainly continue to thrive. We can perhaps expect more moderate levels of leverage – and a certain degree of caution to extend to trading at the more esoteric end of the market – but overall, derivatives activity is expected to remain buoyant. The growing use of exchange and OTC-cleared facilities, such as those offered by Eurex and Eurex Clearing, or ISE and its Options Clearing Corporation, will facilitate this growth and induce greater future stability and resilience in the market.

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79

Exploiting cash and futures markets Many cash-versus-derivatives strategies can be employed on Xetra® and Eurex. Frédéric Ponzo, managing director of financial markets at risk consulting firm NET2S, and Charles Annandale, head of sales and marketing, equity derivatives, at interdealer broker XBZ, explain some of them to Sarfraz Thind

T

here is a variety of ways in which investors can use futures and options to better express their market views and more are constantly emerging. For instance, futures contracts allow investors

to make very straightforward bets on the direction of the market, as well as to enter into very sophisticated spread transactions in which futures positions are tailored to precise views on the likely stock price movements. Low transaction costs; ease of access; transparency and the use of a central counterparty make futures and options markets ideal vehicles for executing such strategies.

Index arbitrage is a common strategy that can be exploited between the Xetra® and Eurex platforms

Index arbitrage is a common strategy that can be exploited between the Xetra® and Eurex platforms. While it can take many forms, one of the most frequent trades involving both cash and derivatives platforms is a cash-and-carry arbitrage in which an investor simultaneously buys the assets on an underlying index, while selling the futures contract to exploit price imbalances between the cash and futures markets. If the futures price exceeds its fair value, the trader can engage in cash-andcarry arbitrage. If the futures price falls below its fair value, the trader can exploit the price discrepancy through a reverse cash-and-carry strategy – an arbitrage that involves selling short the stocks in the index and buying a futures contract on the index. An example of a cash-and-carry arbitrage trade on the Xetra® and Eurex platforms is given below.

An arbitrageur closely monitors price movements in DAX® and DAX® Futures in order to identify potential arbitrage opportunities.

At 9.10 am, the fair value of DAX® is 7,000. The future's fair value and actual

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price is 7,056, thus resulting in an indexfuture fair basis of 56 index points. The contract value of the future is EUR 25 per index point.

At 11.01 am, a sudden market movement caused by a large stop order in the futures market leads to an increase in the value of the futures contract to 7,070, while the index remains at its current price level.

Thus, the index-future basis increases to 70 points.

The arbitrageur decides to take advantage of the changed basis, by selling 100 DAX® Futures contracts at 7,070 and simultaneously buying EUR 17.5 million worth of DAX® shares (the 30 stocks that make up the index with the correct weightings) for an index spot price of 7,000 points.

The trade is carried until expiry of the futures when it is unwound as follows: The index and futures levels are at 7,100 at expiry. The arbitrageur sells back DAX® basket at 7,100, making a profit of 7,100-7,056 = 44 points. This equates to a total cash amount of EUR 17,75 million (the sale price) less EUR 140,000 (the costs of carry) and a profit of EUR 110,000. The future is cash-settled, making a loss of 7,100-7,070 = 30 points. This equates to a cash loss of EUR 75,000. Hence the realised profit is 44-30 = 14 points, which translates

into EUR 110,000 - 75,000, or EUR 35,000.

A reverse cash-and-carry arbitrage occurs when the futures price is below its fair value. In this case, the arbitrageur will follow the same principle, but will buy the futures contracts while selling the underlying cash stocks. In order to honour the short sale commitment on DAX® stocks, the trader will borrow the stock at a specified rate of interest. This can be carried out through the Eurex SecLend lending platform, with stocks being borrowed on a maturity that matches the futures expiry date. The transaction is fully collateralised, either with cash or other securities.

In order to calculate the profit on a reverse cash-and-carry arbitrage trade, the investor needs to calculate the precise number of days until settlement, as well as the futures expiry date, in order to ascertain the exact amount paid for borrowing the securities. One important consideration when entering such a strategy is the lending availability of the chosen stocks. Not all stocks are always lendable and lending rates will change over time with individual lending rates differing substantially according to demand. On average, however, DAX® stocks can be lent at around 20 basis points under normal market conditions.

Mergers and acquisition activity provides ideal conditions for equity derivatives usage

When performing index arbitrage, an investor must buy or sell all of the stocks in the index, a function normally carried out through programme trading methods due to the high volume of trades that need to be executed. An example of this trade on DAX® would typically involve downloading the prices of all 30 stocks, computing the fair price of the index and comparing that to the price of the futures contract. If an index against futures price discrepancy arises, the computer will initiate trades to purchase all 30 stocks. It will also sell the futures contract. Because of the number of stocks involved, performing a successful index arbitrage involves accurate, timely market data, large sums of money and the ability to execute rapidly.

Mergers and acquisition activity provides ideal conditions for equity derivatives usage. Whether the strategy is hedging, gaining upside exposure, overwriting or range trading, volumes generally soar when a merger bid is rumoured or announced.

Given the increased probability of significant gap movements in special situations, options provide an ideal risk management tool with which to maximise returns.

Activity in Volkswagen shares and options at the beginning of the second quarter of 2008 illustrates this well. The VW stock’s 12-month high/low was EUR 197.90/105.10.

As Porsche progressively increased its stake in VW, special situations funds began actively using the options market to fine tune their generally long bias to the stock.

This took the form either of their buying out-of-the-money puts to protect a long stock position (May strike prices on Eurex with the largest open interest were the May 175 and June 180 puts), or of their replacing a long stock position with at- or out-of-the-money calls, so that the bulk of the upside gain was retained, while allowing further upside potential.

In most takeover situations there is a supply of out-of-the-money options from natural ’overwriters’ – funds that seek to maximise their returns by selling options against their long stock holdings. In VW, for instance, pricing on Eurex allowed the

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seller of a June 175/195 strangle to receive a premium of around 4 percent of the underlying stock price. In return for this premium, the seller had to be prepared to sell stock just below EUR 200 if the call strike was breached at expiry or, conversely, to underwrite a further stock purchase of around EUR 171 if the expiry level fell below the put strike.

A range trader, long a particular stock, will often look to enhance returns by using the options market. An example of a structure that might be used to achieve this is the ratio call spread. For example, in February, Company A announced its intention to bid EUR 7.25 per share for Company B. A popular trade in this instance was to buy a June 7.60 call while simultaneously selling twice as many of the June 8.00 calls. This effectively created a profit range of 7.60 to 8.40 on the upside with no downside risk.

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A range trader, long a particular stock, will often look to enhance returns by using the options market The downside of executing such a strategy is visible when the underlying stock rises more than the anticipated amount, in which case there can be a significant loss.

It is not yet clear whether the high levels of volatility that characterised the market in the first nine months of 2008 will remain with us for much longer. However the

ongoing uncertainty, coupled with the likelihood of further corporate activity, means that there should be plentiful opportunity to execute these and similar strategies.

Further information To learn more about XBZ and NET2S, visit: www.xbzltd.com www.net2s.co.uk

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Common equity derivatives trading techniques made easy with Bloomberg Sophisticated tools and techniques are necessary to observe and profit from the sorts of trends and opportunities that are spawned by varying market conditions. Bloombergâ&#x20AC;&#x2122;s Carole Bernard examines how Bloomberg can be used to help understand market behaviour, generate ideas and to price and monitor trades

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T

he tumultuous market conditions that began to unfold in 2007 and continued well into 2008 resulted in volatility spiking across all major markets. At the beginning of the second quarter of 2008, however, a more subdued period of lower volatility followed, opening the door to some different trading opportunities. Sophisticated tools and techniques are, of course, necessary to observe and profit from the sorts of trends and opportunities that are spawned by such market conditions.

In this chapter we will examine how the Bloomberg terminal can help you understand market behaviour and generate ideas. We will also explore how it can be used to price and monitor trades.

The credit crunch coupled with the economic uncertainty experienced in early 2008 resulted in rocketing volatility on the major indexes; implied and realised volatilities reached levels of more than 30 percent. By the middle of the second quarter, they had started to return to more subdued levels in the low 20 percent1 range. Coupled with behaviour of other major volatility indicators, it became clear there had been a gradual return towards more fundamental analysis which, in turn, allowed investors to seek out relative value through dispersion trading or sector analysis.

Futures prices do not always trade at their fair values. Bloomberg has created an overview functionality that allows investors to check if and to what extent a futures price is trading away from its fair value and exploit possible arbitrage opportunities. FV<GO> or XFUT<GO> are both ideal tools through which to conduct detailed analysis on the relative value of the underlying stock or index and its futures contract, and to isolate trading opportunities by identifying overpriced and underpriced securities.

The changes in regulation brought in by the UCITS III regime2, the rise of 130/30 funds

Table 1: market overview on major indexes and indicators

Medium-term volatility This graphic is based on the G <GO> screen. The graphs show implied volatility (IV) short term, medium term and variance swaps. Similar analysis can be done to review cheap/expensive stock/indexes volatility at a single underlying level using HVG<GO>.

TRMS<GO> gives an overview of the term structure of realised and implied volatility. SKEW<GO> and VCMP<GO> show the effect of the selected strike and term upon the premium paid over time.

GV<GO> will soon be launched as a one-stop shop for analysing volatility on any given underlying or multiple underlying assets.

To review market volatility across major indexes, press WVI <GO> World Volatility.

The credit crunch coupled with the economic uncertainty experienced in early 2008 resulted in rocketing volatility on the major indexes

See table 1 for a market overview with major indexes volatility and cross asset overview.

UCITS: Undertakings for Collective Investments in Transferable Securities.

1 2

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Dispersion trading is a strategy that gives exposure to the average correlation of a stock market index and its components Table 2: volatility comparison

XVCT Volatility comparison The sub-sector analysis shown here can be used to isolate trading ideas.

These pages are useful for quickly examining the sector, universe, index, best and worst volatility performers and ranges of volatility over time.

They are ideal tools for dispersion and spread trading and for structured notes.

and increased liquidity in the single stock futures (SSF) market have combined to give portfolio managers additional tools for implementing traditional delta-1 strategies, such as pairs trading.

Variance swaps and dispersion trading are the most commonly used techniques by those seeking a more direct means of trading index volatility. Variance swaps give investors direct access to volatility by capturing the daily returns of variance. In turn, this means that they are able to gain direct exposure to volatility, avoiding the

convex payoff found in more traditional volatility strategies such as straddle or strangle trades. Market monitoring can be done through VSV or GRCH3, both of which will give you a fair value of the index/stock variance swap level. Mark-tomarket can be done through OVME. Thereafter, trade monitoring and trade opportunities can be done through lpad or on custom files such as IDOC 2029275 – VS strategies monitoring.

Dispersion trading is a strategy that gives exposure to the average correlation of a

stock market index and its components. It requires a close observation of index volatility versus its components to isolate richness and cheapness between the index and its components observing historical and implied volatility. XDIS is a simple and efficient tool to review the dispersion level across indexes and analyse the historical behaviour of dispersion.

Finding relative value in index sectors can be done through the XVCT function, which gives a walk-through of volatility comparison tools. For instance, a quick glance at the Dow Jones STOXX® 600 Sectors would isolate the best and worst performers.

In the example shown in table 2, we can easily see that the Banking (SXFP) has been the worst performer with the widest volatility range over the period and a currently above-average volatility. Food (SX3P) has had one of the lowest spreads on average and has a current volatility slightly above 16 percent4.

Trade ideas are often generated by abnormal volume and or by volatility levels – but to exploit these, the levels need to be quickly and efficiently identified. This market sweeping can be simplified by using the Bloomberg screener for option volume increase (OVI), which will screen any abnormal volume movement compared to the average for the underlying stock on the exchange selected. For instance, by pressing OVI_GR<GO>, any abnormal volume in call or put options listed on Eurex will be highlighted. Table 2 shows a large amount of calls of longer than four months in Allianz options. The high proportion of calls and call spreads (110/120) is illustrative of positive market sentiment in the stock and is reflective of the then current market view that arose from consolidation talks.

OMON shows market liquidity, while OMST shows the volatility changes on the June expiry. The trade can be crystallised through OSA with a call spread 110/120 costing EUR 8.49 per units.

More customised strategies can be tested through the OVME screen, on which one can price both single and multi-leg deals. OVME allows you to work with both listed or over-the-counter options that can thereafter be marked to market in OSA.

VSV and GRCH to monitor the fair valuation level of variance swaps in a listed option market or through a Garch valuation. For more details on variance swaps refer to IDOC 2029290 on Bloomberg.

XVCT gives a full overview on the selected universe of the volatility distribution, showing the best and worst performers within the selection – refer to table 2 for full details of the example mentioned.

3 4

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Table 3: credit versus equity

OVCR – Equity and credit volatility risk – select the security of your choice to see the historical spread between the CDS market spread and implied spread to review the robustness of the trade.

An example: Deutsche Post’s second quarter results have impacted on their call options, which are shown as being highly liquid compared to the average. Looking further into the Deutsche Post activity details in OMST, we can see that more than 26,000 call options were traded on the day in question, most of which were on the June expiry. The varying trade levels indicate that there was range-bound trading through call spreads. This strategy, with a long 22/short 24 strike will give a maximum of EUR 6 return per position for less than EUR 4 expense, breaking even above a strike of EUR 23.65.

In this last section we will focus on some other trading strategies that can easily be monitored using Bloomberg.

On the flow trading side, a common relative value trade is done through a synthetic index rather than an option. This strategy has been facilitated through the rapid development of the exchange traded funds (ETFs) market, which is now sufficiently liquid to enable investors to trade the index versus its ETF of reference, or the returns of various indexed-based ETFs against each other.

EXTF gives you an overview of the ETF market. For more detailed analysis of individual funds and to examine the rela-

tionship between funds and their reference indexes, there are a number of other functionalities. See HFA<GO for historical fund analysis; HS<GO> for historical spread analysis and PORT<GO> for portfolio analytics.

Increased liquidity in the credit and equity options markets, has led to crossasset trading opportunities. The relationship between credit and equity can be observed through OVCR, allowing users to compare any selected index or security to other index components or industry peers.

Equity volatility can be deleveraged to calculate the probability of default of the asset using BS and a Merton model. This allows you to compare a company’s credit default swap with its corresponding implied equity spread and isolate trading opportunities.

Table 3 shows some of the Dow Jones STOXX® 600 components. In the graphic, Daimler shows a good average level with an implied spread (IS) that is cheap compared to the level of its credit default swap – IS 16.95 percent versus 58.70 percent.

Observation of the trade demonstrates that the drop in the implied spread was faster than the drop in its CDS, in line with market sentiment.

The need to access information quickly

and efficiently, to monitor markets, secure accurate pricing and to mark strategies to market has been highlighted like never before in recent months. The expanding range of Bloomberg functionalities have considerably eased this task.

Bloomberg Professional service Bloomberg’s founding vision in 1981 was to create an information service, news, media company that provides business and financial professionals with the tools and data they need on a single, all-inclusive platform. The success of Bloomberg is due to the constant innovation of our products, unrivalled dedication to customer service and the unique way in which we constantly adapt to an ever-changing marketplace.

Carole Bernard Carole is a derivatives specialist at Bloomberg Professional service. She has an MSC in international finance from Brunel University and now focuses on derivatives, in particular on equity derivatives and cross asset trading.

Contact Carole Bernard Cbernard2@Bloomberg.net Tel: +44 (0) 207 673 2553

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Pricing structured products with Eurex A conspicuous amount of empirical work on structured product pricing has been produced in recent years, doubtless stimulated by the size and growth of the structured product market. Many studies have analysed primary and secondary market structured product pricing against equivalent strategies in the underlying markets. Dr Ralf Seiz cites several recent academic investigations in which Eurex-listed options were used to replicate structured products

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he transfer of pricing information derived from Eurex options faces a problem of pricing model-dependency. The extraction of implied volatilities from Eurextraded options depends on the particular valuation model selected. Using the Black-Scholes model, some empirical phenomena occur: implied volatilities depend on option â&#x20AC;&#x2DC;moneynessâ&#x20AC;&#x2122; (the so-called smile effect) and time-to-maturity (the term structure effect). Thus, when assigning these implied volatilities to structured products with plain-vanilla options, differences in both strike and time-to-maturity need to be minimised. The matching mechanism can be demanding, since priority must be given to differences in either strike or time-tomaturity in a one-dimensional approach.

It is widely known from empirical research that the smile effect of implied volatility is more pronounced than the term structure effect, thus priority is usually given to differences in strike prices. In the case of structured products with implicit exotic options, an additional assumption is necessary when using Eurex-extracted implied volatilities from plain-vanilla options for valuation purposes. The implied

Black-Scholes volatility must be a suitable input parameter for the valuation model of the exotic options.

Burth et al. 2001 An early pricing study of Swiss structured products was conducted by Burth et al.

(2001). This examined the pricing of 199 reverse convertibles and 76 discount certificates. They analysed the initial pricing of these 275 products, by comparing them to equivalent strategies in the underlying markets. The Eurex options that were used to replicate the structured product had to match the characteristics of the products as closely as possible.

In each case, the Eurex contract that best reflected the productâ&#x20AC;&#x2122;s investment characteristics according to its strike price and its time-to-maturity was selected. The criteria were adjusted for potential smile effects, as well as for the term structure effects of the implied volatilities.

The study showed that the misvaluation of the structured products was, on average, biased against the investor and differed considerably among issuers, as well as between coupon-paying reverse convertibles and discount certificates. It also demonstrated that structured products with coupons had significantly more biased pricing than those without a coupon.

It is widely known from empirical research that the smile effect of implied volatility is more pronounced than the term structure effect

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Wilkens et al. 2003 For the German market, Wilkens et al.

(2003) conduct a similar study, analysing the pricing of 910 reverse convertibles and discount certificates during a one month timeframe, based on duplication strategies using call options traded on Eurex.

In their pricing study, they observed declining pricing errors during the product life cycle. To judge product prices, implied option positions were compared to options traded at Eurex. Stock options at Eurex are American-style (in other words, they exercise prior to maturity).

The Black-Scholes model can be applied to these options, only if it can be assured that early exercise is never optimal. Therefore, the authors used the relation that early exercise could be rational only immediately prior to a dividend date. Only those Eurex options that satisfied these verifications were treated as pure European options.

A further issue was the interpolation and extrapolation of implied volatilities. Many structured products represent embedded option positions that are far out-of-themoney or far in-the-money. In this case, two or more volatilities from Eurex options had to be used for a one-dimensional linear or nonlinear extrapolation. This required assumptions about the smile pattern beyond observable strikes. For intermediate strike levels, interpolation of Eurex implied volatilities was feasible, although of limited use: because distances between the Eurex strikes were rather small, interpolated values did not produce much better estimates than those at observable strikes.

Furthermore, many of the structured products had a much longer time-tomaturity than Eurex options. In these cases, extrapolation was even more critical, since it required volatility estimates for long times-to-maturity from short-term Eurex options. Consequently, crucial assumptions on the volatility term structure were necessary. The joint two-dimensional interpolation and/or extrapolation along dimensions of moneyness and time-to-maturity would probably have been the best choice.

However, linearity assumptions and large

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differences in both parameters due to Eurex options having strikes near at-the-money and rather short times-to-maturity, called these techniques into question.

Grünbichler and Wohlwend 2005 A recent study by Grünbichler and Wohlwend (2005) analysed the valuation of 192 Swiss structured products without capital guarantees. Their investigation took into account both the primary and the secondary markets.

The central element of the study was a comparison of the implied volatilities of the options contained in structured products with the implied volatilities of comparable Eurex options. Because Eurex stock options are American-style, the authors implemented the COX et al. (1979) model to generate the implied volatilities. Eurex provided the daily statistics for options on Swiss equities for the period from June 1998 to March 2000. Each structured product then had a Eurex put option assigned to it whose characteristics (strike price and time-tomaturity) were as similar as possible.

First, the authors tried to minimise the difference in the time-to-maturity between the structured product and the Eurex option. From the remaining Eurex options, they chose the one with the smallest deviation in strike price.

The results showed that the structured products were, on average, valued to the investors’ disadvantage at the time of issue.

In general, market misevaluations to the investors’ disadvantage were also detected in the secondary market, although the extent of this phenomenon was found to be considerably less pronounced than at the time of issue.

Stoimenov and Wilkens 2005 The analysis of Stoimenov and Wilkens (2005) is one of just a few studies that have examined German structured products with implicit exotic options – namely barrier and rainbow options. In this study, the daily closing prices of a large variety of structured products were compared to theoretical values derived from the prices of options traded on Eurex.

Since structured products are generally European-style, they employed only European Eurex options to evaluate product prices. While Eurex’s DAX® Options

are European-style, Eurex stock options are American-style and can be exercised at any time prior to maturity. Thus, their approach required the exclusion of all American stock put options, as well as those American call options that could have been exercised prematurely. The prices, and thus the implied Black-Scholes volatilities of this selection of Eurex call stock options, together with Eurex call DAX® Options, provided the basis for valuing the productembedded options.

The main results can be summarised as follows: in the primary market, all structured products were priced, on average, above their theoretical values. The study also provided evidence that products with embedded exotic options were subject to even higher premiums than common classic products. In the secondary market, the surcharges systematically decreased as the products approached maturity. This phenomenon held for almost all subgroups of products and indicated that, in the case of repurchases, the issuing bank netted the premium difference as profit.

Wilkens and Stoimenov 2007 Wilkens and Stoimenov described an empirical analysis of the pricing of leveraged products in the German retail market. These are mainly exchange-traded products that have an impressive amount of trading volume and are theoretically equivalent to one-sided barrier options.

Issuers’ daily quotes for stock index products were compared to theoretical values derived from the prices of Eurex options and to boundaries obtained from semi-static superhedging strategies.

The authors limited their analysis to quotes on leveraged products made between 5.29 pm and 5.31 pm. They did this because they wanted to derive suitable market volatility proxies from Eurex, and the exchange’s settlement prices are set at the close of the trading day at 5.30 pm.

Eurex’s DAX® Options, are plain-vanilla European-style and standardised in terms of strike and time-to maturity. The authors showed that, on average, ask quotes for long and short certificates significantly exceeded theoretical values and even superhedging boundaries. Thus, where investors pursued buy-and-hold strategies and issuers were suitably hedged, the latter realised almost risk-free profits.

Lindauer and Seiz 2008 Finally, Lindauer and Seiz (2008) examined the pricing of (multi-) barrier reverse convertibles in the Swiss market. These are structured products with exotic characteristics that have a knock-in feature and are usually specified as ‘worst of’ products.

The daily closing prices of 522 products between July 2006 and August 2007 were provided by SCOACH, a joint venture between SWX Swiss Exchange and Deutsche

The analysis of Stoimenov and Wilkens (2005) is one of a few studies that examined German structured products with implicit exotic options

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Börse for structured products. These prices were then compared to their theoretical values based on Monte Carlo simulations.

The investigation took both primary and secondary market prices into account. The replication strategy used implied volatilities from near at-the-money Eurex option prices. In the primary market, the study revealed large implicit premiums in favour of the issuing banks. For the secondary market, the product life-cycle turned out to be a decisive pricing parameter, as pricing errors clearly decreased during the products’ life cycle. The expectation of the issuers regarding the order flow might be an explanation for this phenomenon; however, the study’s results clearly demonstrated that structured products tend to be overvalued at issue, and have a tendency to be undervalued in the secondary market.

These empirical investigations demonstrated that a liquid and standardised derivative exchange such as Eurex is vitally important as a mechanism from which to derive and transfer pricing information, because the information content is crucial for any financial engineering work, such as structured product replication.

Dr Ralf Seiz Dr Seiz is lecturer of finance at the University of St. Gallen (HSG). He studied physics at ETH Zurich (Dipl. Phys. ETH) and worked at CERN in Geneva and as a lecturer of financial mathematics. Before starting his PhD at University of St Gallen (Dr oec. HSG), Ralf Seiz worked for Accenture as a business analyst in the strategy department and advised a variety of financial services companies. Dr Seiz has also been visiting research scholar at New York University, Stern School of Business. His main research and consulting areas are: derivatives, financial engineering, structured products, hybrid securities, executive compensation, risk management, alternative investments and asset management.

In addition, he is managing partner and member of the board of Algofin AG, a quantitative finance consulting company.

Contact Swiss Institute of Banking and Finance University of St Gallen Tel: +41 71 224 70 29 Email: ralf.seiz@unisg.ch

89

A liquid and standardised derivative exchange such as Eurex is vitally important as a mechanism from which to derive and transfer pricing information

References Burth, S., Kraus, T. and Wohlwend, H., 2001, The Pricing of Structured Products in the Swiss Market, Journal of Derivatives 9 (2), 30-40.

Cox, J.S., Ross, S. and Rubinstein, M., 1979, Option Pricing: A Simplified Approach, Journal of Financial Economics 7, 229–264.

Grünbichler, A. and Wohlwend, H., 2005, The Valuation of Structured Products: Empirical Findings for the Swiss Market, Financial Markets and Portfolio Management 19 (4), 361-380.

Lindauer, T. and Seiz, R., 2008, Pricing (Multi) Barrier Reverse Convertibles, Working Paper University of St. Gallen.

Stoimenov, P. A. and Wilkens, S., 2005, Are Structured Products Fairly Priced? An Analysis of the German Market for Equity-Linked Instruments, Journal of Banking & Finance 29, 2971-2993.

Stoimenov, P. A. and Wilkens, S., 2007, The pricing of leverage products: An empirical investigation of the German market for ‘long’ and ‘short’ stock index certificates Journal of Banking & Finance 31, 735–750.

Wilkens, S., Erner, C. and Röder, K., 2003, The Pricing of Structured Products in Germany, Journal of Derivatives 11, 55-69.

EUREX_RJF LC

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Page 1

Equity Derivatives

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Inflation Derivatives

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and Hedge Funds in the UK, Europe and Asia.

We are renowned for selecting Front Office Equity Derivatives individuals for Sales, Trading, Research and Structuring

Commodity Derivatives

positions in listed and Otc markets.

For further information and a confidential discussion contact: Richard Fraser

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RJF Global Search, 32 Threadneedle Street, London EC2R 8AY 0207 469 4858 Info@rjfglobalsearch.com www.rjfglobalsearch.com

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91

Surveying the future Natasha de Terán takes a look at the outlook for the equity derivatives market and the increasingly pivotal role that exchanges and central counterparties will play within it

I

f we were to summarise the prognosis for the equity derivatives market in a single word, it would have to be 'growth'. The equity derivatives market has already grown considerably over the last 35 years in volume terms, but the real growth is almost certainly ahead of us.

Similarly, the number of instruments, and the range of applications to which they are put, has expanded exponentially; but here, too, we will see many more developments in the years to come.

Underpinning much of this growth is one fundamental factor: the growth in the

global equity market culture. This said, there are also plenty of other influencing factors – key among them are: the heightened risk-management awareness and increased investor sophistication; the ongoing product evolution and the growing power of technology; the globalisation of derivatives markets; and the expansion of regulated and cleared markets.

The tumultuous performance of equity markets over the last decade has meant that even the youngest individuals within the equity investing community have fresh experience of equity market downturns and will be keenly aware of the importance of risk management.

The growing sophistication of both investors and product providers has gen-

erated and will continue to generate a wealth of ideas, the need for diversification, the drive for alpha and the aforementioned hedging and risk-management drivers will also continue unabated. The result of this is that the focus on equity derivatives will increase substantially as investors and providers dedicate greater resources, and higher headcounts, to these areas.

On the product side, we must remember that both the over-the-counter and exchange traded equity derivatives markets are really just a few decades old – they are still in their infancy. This means that while product innovation has been prolific, perhaps we have only seen the very beginning of this trend.

Many of the instruments and strategies we now consider almost commonplace –

While product innovation has been prolific, perhaps we have only seen the very beginning of this trend

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Electronic trading and improvements in connectivity have made derivatives more global than other instruments

such as structured products, dividend and variance swaps, dispersion and correlation trading – have just a few years’ history, while their listed equivalents are even newer. These instruments and strategies will find new user bases and applications in the years to come; trading volumes will increase commensurately and the resulting increase in liquidity will, in turn, attract new market entrants.

Increased computing power, the growth of electronic markets and improvements in connectivity have perhaps been the singlemost influential factors in the market’s development over the last ten years and they will undoubtedly continue to act as market protagonists over the next ten. As algorithmic trading moves deeper into the derivatives world; as connectivity costs decrease and trading speeds accelerate, we will likely see the same sort of concerted explosion in trading volumes as that experienced in the cash equity markets in recent times.

Electronic trading and improvements in connectivity have made derivatives more global than other instruments. Eurex has been at the forefront of this trend, operating 15 access points in major international financial centres around the world, and listing derivatives on a wide geographical range of underlyings.

Eurex will be expanding its international reach even further in the second half of 2009, when the new transatlantic trading and clearing link will allow Eurex customers to access ISE’s options market using their

existing Eurex connections. The link will give Eurex members access to the full suite of options products available at ISE and enable them to execute orders in the ISE order book using their existing connectivity to Eurex.

Additionally, to encourage participation from afield, Eurex has introduced a trader development programme for new markets, covering participants from markets such as China, India and Malaysia. It established a telecommunications hub in Singapore in 2006, and the following year became the

first international derivatives exchange to establish such a hub in Dubai.

Initiatives such as these are important because it is likely that the Indian and Middle Eastern economies will be the major catalysts of growth in the equity derivatives markets over the coming years. Equity derivatives usage will be stimulated by the growing wealth in these two regions for two principle reasons: on the one hand, Western investors will want to seek out cheap market beta exposure to their fast-growing economies; on the other, local investors will

Graphic 1

On exchange

Value chain and function

OTC

Bilaterally cleared

CCP - cleared1

Derivatives pre-trading • Origination and brokerage of trades from end-customers

Derivatives broker-dealers (mostly large universal and investment banks)

Derivatives trading, clearing and exercise • Matching of buy and sell orders • Market making

Derivatives exchanges

• Reconcilliation of trades • Risk management and risk mitigation • (Exercise of contracts)

Clearing houses

Payment and delivery • Transfer of ownership of cash (and underlying) resulting from derivitives transactions

Central banks2

Agent/ custodian banks3

ICSDs/CSDs 1) Only a small portion (< 10%) of OTC derivatives is CCP-cleared 2) Payments via central bank money 3) Payments via commercial bank money

Source: White Paper: The Global Derivatives Market – An Introduction. Deutsche Börse Group 2008

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likely use the instruments for diversification and risk management purposes.

Finally, the two most important protagonists of the equity derivatives markets in the coming years: regulated exchanges and clearing houses.

The regulated exchanges already have a solid footing in the equity derivatives Graphic 2 Exhibit 12: Total transaction costs for end customers per E1 million notional amount â&#x20AC;&#x201C; on-exchange vs. OTC Estimates for Europe 2006 E per E1 million notional amount traded1

55.0

60

40

20

x8

10 7.0 5

3.8 3.2

0 On - exchange2

OTC3

Pre-trading and market making (broker-dealers) Trading and clearing (exchanges and clearing houses) 1) Explicit (trading and clearing fees) and implicit (bid/ask spread from market makers) for both sides of a transaction 2) Broker-dealer data for EMEA European derivatives exchanges and clearing houses 3) Based on broker-dealer revenue data for EMEA; notional amounts traded based on BIS data for interest rate and foreign exchange derivatives scaled up to reflect total market (fixed-income and foreign exchange derivatives account for 78 percent of market in terms of amounts outstanding) Source: BIS, WFE, annual reports, Mckinsey

Source: White Paper: The Global Derivatives Market â&#x20AC;&#x201C; An Introduction. Deutsche BĂśrse Group 2008

landscape, but their reach will extend far wider and deeper as these markets develop in the coming years. Exchanges will add to their product armouries with a wider range of contracts and trading tools.

Furthermore, as a greater number of OTC products become standardised, they will migrate to the exchange traded environment. Pricing and transparency issues experienced during the credit crunch have brought risk management and regulatory considerations to the forefront, and these will doubtless propel this trend forward with significant momentum.

These same factors, coupled with changes to capital requirements and a desire to limit counterparty credit, market, legal and operational risk, will meanwhile drive a greater amount of OTC business toward central counterparties, such as Eurex Clearing.

When OTC and exchange-look-alike contracts can be easily, efficiently and cost-effectively given up to central counterparties, they will be. Higher funding costs will be passed on to clients with the result that delta-1 products, such as total return swaps, will no longer prove so attractive. Where possible they will be replaced by exchange contracts; where not, investors will seek out alternatives and give up the trade to central counterparties. Investors will thus benefit from independent pricing and risk calculations managed and distributed in real time.

Robust risk management tools and practices, combined with centralised margin

93

pools with potential risk offsets, can potentially provide significant cost savings.

A transition towards CCP intermediation has been under way for some time.

Three factors may accelerate this shift.

First, CCP intermediation will be more attractive as capital and liquidity requirements become more stringent. Netting out individual transactions reduces capital requirements relative to trading in OTC markets. Second, even the most creditworthy intermediaries may judge that mutualisation of counterparty risks no longer weakens their competitive advantage, because systemic fragility links their interests with the financial convoy.

Last, operating savings from an effective clearing regime may be notable, as netting reduces settlement requirements.

As policymakers take on the complex task of securing the financial system after the storm, they will look to market mechanisms such as CCPs to advance their objectives.

Centralised counterparties could lessen systemic risk, said Lewis Alexander, Citigroup chief economist, writing in the Financial Times, June 5, 2008.

The efficiency gains resulting from the use of electronic trading, regulated markets and CCP services should free up human and financial capital. These evermore precious resources will instead be allocated to further trading activities, to servicing and supporting more complex strategies and, of course, to innovation.

EUREX_SWX LC

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Page 1

Showing the way: the SLI Swiss ® Leader Index Liquid compass: a Swiss invention

by Recta, 1941

Since its launch on 2 July 2007, the SLI Swiss Leader Index® has developed very favourably. And it promises great things for the future. The potential of this new index, which includes the 30 largest and most liquid stocks in the SPI®, lies in its limitation of the index weighting by means of a 9/4.5 capping model and the optimal share and sector diversification it therefore offers. It also fulfils all Swiss, EU and US regulatory specifications, which in turn enables new markets to be opened up. For many experts, it is precisely these advantages that could make the SLI® a generally recognised Swiss benchmark index over the long term.

www.swx.com

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From pure protection to real asymmetric profiles Dynagestâ&#x20AC;&#x2122;s Dr RenĂŠ Sieber explains how portfolio insurance techniques have evolved and facilitated the development of a new generation of products

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C

onstant Proportion Portfolio Insurance1 (CPPI) is now an established technique, but the objective of CPPIbased investment has progressively shifted in recent years. Where previously the aim was to use CPPI to protect the absolute investment floors, today it is being used to devise investments with truly asymmetric return profiles.

This more flexible application of portfolio insurance techniques has made it possible to launch a new generation of products that are better able to cope with higher volatilities and lower short-term interest rates.

The aim of this short study is to summarise some aspects of this evolution based on some examples using DAX®.

We present the pro forma results of different CPPI-based approaches on DAX®

because the index itself has historically been characterised by substantial volatility. The study considers different variants of the Time Invariant Portfolio Protection2 (TIPP) concept, also known as the ‘dynamic ratchet’.

Pro forma management is performed using exclusively Eurex futures contracts on DAX® (FDAX). According to the applied portfolio insurance principles, the futures are sold or bought in order to adjust the exposure of an existing long spot position on the underlying index (an indexed portfolio) representing 100 percent of the initial value of the investment. As well as the quarterly rollover of open positions, transactions occur, if necessary, once a day on

97

the futures closing prices. The results shown in table 1 are net of management and transaction fees.

Towards more reactive approaches There are many variations that could be used, some of which we describe below and some that are also depicted in chart 1. With the exception of variant 7, all the variants illustrated use a base level of authorised exposure of 100 percent.

Variant 1 corresponds to a ‘pure’ version of ‘dynamic ratchet’ in which the aim is to protect a floor representing 90 percent of the initial investment, and to lock in the highest value reached during the life of the

The objective of CPPI-based investment has progressively shifted in recent years

Table 1: simulated net performances of different CPPI-based approaches on DAX®: 1993-2007 1993-2007 Return

01/01/97-07/03/00

Volatility Sortino

Sortino

07/03/00-12/03/03 Level

1

1

Level

Return

12/03/03-31/12/07

Return

Volatility

in % (p.a)

in %

ratio

in % (p.a)

in %

ratio

Volatility

11.7%

22.6%

0.39

38.1%

25.6%

1.48

522

143

-35.0%

32.5%

522

13.6%

0.32

14.1%

20.4%

0.60

231

208

-3.4%

10.9%

13.5%

0.42

16.6%

19.4%

0.76

253

216

-5.2%

13.7%

0.45

26.6%

19.6%

1.33

329

220

13.6%

0.48

19.1%

19.5%

0.90

275

14.3%

0.60

25.9%

18.9%

1.33

14.7%

0.58

29.6%

19.4%

17.4%

0.76

41.8%

21.8%

07/03/00 12/03/03 in % (p.a) in % (p.a)

Level

1

Return

31/12/07 in % (p.a)

Volatility Sortino in %

ratio

31.0%

17.9%

1.84

299

7.9%

9.8%

0.58

11.0%

359

11.2%

10.5%

0.89

-12.5%

13.0%

373

11.6%

9.3%

1.07

227

-6.2%

10.6%

397

12.4%

10.9%

0.97

348

235

-12.3%

11.0%

506

17.3%

13.9%

1.21

1.51

382

228

-15.8%

13.7%

508

18.1%

12.8%

1.33

2.00

601

334

-17.7%

13.7%

880

22.4%

17.2%

1.25

135

152

4.0%

173

2.7%

Underlying equity market DAX®

Dymnamic Ratxhet - net of fees 1 <Pure> 7.6% (90%/100%) 2 <Pure> 8.9% (85%/100%) 3 Minimum exposure of 30% 9.2% (85%/100%) 4 Fees charged to the floor 9.6% (85%/100%) 5 Conditional exposure recapture 11.4% (85%/100%)4 6 Combination <3-4-5> 11.4% (85%/100%) 7 Combination <3-4-5> leveraged 15.6% (80%/150%) 2’3

Short-term

3.7%

3.1%

1) Base = 100 on 1 January 1993.

2) Management fee of 1% p.a and transaction fees.

3) For each CPPI-based approach, the information in parenthesis indicates the base level of the floor and of authorised exposure.

4) Conditional floor lowering: 3.5% at most of the initial investment value during the 1st year, 7% at the most on the previous year-end value of the investment during the following years.

1

See Fisher Black & Robert Jones, Simplifying Portfolio Insurance, Goldman Sachs Research Report, August 1986 and Journal of Portfolio Management, Fall 1987.

See A. Perold & W. Sharpe, Dynamic Strategies for Asset Allocation, Financial Analysts Journal, January-February 1988.

2

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Table 2: simulated transactions volumes of different CPPI-based approaches on DAX®: 1993-2007 1993-2007 Trades

01/01/97-07/03/00

# of contracts 2

Trades 3

08/03/00-12/03/03

# of contracts 2

Trades 3

per week

per trade

per week

per week

per trade

per week

30

129

387

2.7

169

454

2.7

27

99

263

3.2

113

362

1.4

127

179

2.1

142

26

107

276

3.2

23

148

340

1.8

162

1.8

308

1 <Pure> (90%/100%) 2 <Pure> (85%/100%) 3 Minimum exposure of 30% (85%/100%) 4 Fees charged to the floor (85%/100%) 5 Conditional exposure recapture (85%/100%) 6 Combination <3-4-5> (85%/100%) 7 Combination <3-4-5> leveraged (80%/150%)

13/03/03-31/12/07

# of contracts

per week per trade

2

Trades 3

# of contracts 2

3

per week

per week

per trade

per week

73

205

3.3

103

337

3.7

52

147

2.2

97

215

301

0.8

70

380

0.8

98

83

119

381

3.8

59

149

2.0

116

229

3.0

145

429

3.3

89

176

1.7

201

347

294

2.3

167

382

1.9

101

222

1.6

191

302

564

2.2

284

639

1.9

179

264

1.7

448

775

1) Average number of trades per week, quarterly rollovers not included.

2) Average number of DAX® Futures contracts (sold or bought) per trade for an initial investment amount of DEM 200 millions, quarterly rollovers not included.

3) Average number of DAX® Futures contracts traded (sold or bought) per week for an initial investment amount of DEM 200 million, quarterly rollovers not included.

investment, ie, an absolute floor that can only be adjusted upwards.

Variant 2 also represents a ‘pure’ version, but with a floor level of 85 percent, which means smaller exposure adjustments (see table 2).

Although variants 3 to 5 all have the same floor level of 85 percent, each of them integrates distinct elements that make them more reactive to the upside, while preserving their protective nature.

Variant 3, for instance, maintains a minimum level of exposure of 30 percent.

Thus, even if the underlying asset falls in price, the exposure does not fall below this minimum, so the investment value can

actually decline below the level reached by the floor. In this way one can switch from CPPI to a ‘constant-mix’, in which the floor becomes a ‘soft floor’.

In variant 4, management and transaction fees are charged on the floor, meaning that the fees do not affect the exposure management.

In variant 5, we can lower the floor in order to recapture exposure when the underlying asset falls in price. These recaptures are based on a predefined additional annual risk budget and will depend on the evolution of the underlying. In this case, they are based on a statistical model that identifies extreme downside movements in DAX®.

Chart 1: simulated net performance of variants 2, 4, 6 and 7 1000 DAX® : + 422.1% (+11.7% p.a) / vol 22.8%

767 588 450

Variant 2 : + 258.8% (+8.9% p.a) / vol 13.5% Variant 4 : + 297.4% (+9.6% p.a) / vol 13.6% Variant 6 : + 407.7% (+11.4% p.a) / vol 14.7% Variant 7 : + 780.0% (+15.5% p.a) / vol 17.4% Short term : + 72.7% (+3.7% p.a)

345 265 203 155 119 91 70 31.12.92

31.12.95

Source: Dynagest S. A Geneva

31.12.98

31.12.01

31.12.04

31.12.07

The two remaining variants, 6 and 7 combine the three elements described above.

While variant 6 considers a base exposure of 100 percent, variant 7 introduces leverage with a base exposure of 150 percent, the exposure above 100 percent being taken through long positions in the futures market.

Long-term advantages The period taken into account for the pro forma management covers the 15-year period from 1993 to 2007. This period is particularly illustrative of the differences between the various CPPI-based portfolio approaches, as it covers not only a major ‘speculative’ bubble (from 1997 to 2000), but also one of the most severe corrections experienced by equity markets, followed by one of the most spectacular rebounds.

Over the whole period, DAX® has experienced an average return of 11.6 percent per annum. Variant 1 – the ‘pure’ version of ‘dynamic ratchet’ with a 90 percent floor – would have achieved a performance, net of fees, of 7.6 percent p.a.

With an 85 percent floor, the average return with a ‘pure’ CPPI would have delivered a much improved return of 8.9 percent p.a. This result is interesting since it highlights the fact that, despite a lower initial level of protection, the implied lower cost of hedging makes it possible to raise the floor over time to a higher level. At the end of 2007, the floor was 213 percent above the initial investment in variant 2,

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while it stood at 179 percent in variant 1.

The return could be further improved using one of the four other variants on a base level of 100 percent for the authorised exposure and 85 percent for the floor. Variant 4 is of particular interest, since by merit of having charged the fees on the floor, it was possible to increase the average annual return from 8.9 percent to 9.6 percent.

The best results, however, come when one conditionally increases the exposure as the price of the underlying falls. With variants 5 and 6 and a net annual return of 11.4 percent, it was possible to achieve a performance close to the underlying index, but with average volatilities of 14.3 percent and 14.7 percent respectively – significantly lower than the 22.6 percent of the index itself.

Finally, in variant 7, which has a base level of 150 percent for the authorised exposure and 80 percent for the floor, it was possible to generate a net out-performance of almost 400 basis points p.a., with a volatility of 17.4 percent, despite an average effective exposure of close to 100 percent.

Coping with a ‘collapse’ and a strong recovery Analysing the two sub-periods that correspond to the stock market collapse from March 2000 to March 2003, and the strong recovery that ensued and continued until 2007, highlights several interesting points. First, the ‘pure’ versions provided the expected protection during the first sub-period. With an underlying index that lost almost 73 percent (35 percent p.a.) from the value reached on 7 March, 2000, these two variants helped to limit the decline of the investment to 10 percent (3.4 percent p.a.) and 14.8 percent (5.2 percent p.a.) respectively.

During the ensuing recovery that saw DAX® increase by 226.2 percent (31 percent p.a.) from its value on 18 March, 2003 the performance of the two ‘pure’ variants was limited by the fact that the exposure, which had been reduced to almost zero, needed quite some time before rebuilding to its base level of 100 percent. However, with average annual returns of 7.9 percent and 11.2 percent, the investments at the end of 2007 were significantly above the levels reached on 7 March, 2000 (29.5 percent and 41.6 percent higher, respectively), while the

recovery in the index brought it back to its March 2003 peak level.

It should come as no surprise that the more reactive approaches – and particularly those that have conditional exposure recapture – offered less protection during the ‘collapse’. In variants 5 and 6, investors would have lost 12.3 percent p.a. and 15.8 percent p.a. respectively, although in return they would have benefited from substantially higher returns during the recovery (17.3 percent p.a. and 18.1 percent p.a.).

Such returns also made it possible to bring the value of the investment at the end of 2007, well above the levels reached on 7 March, 2000 (45.3 percent and 32.8 percent above, respectively).

Finally, the leveraged variant proved to be the least protective during the ‘collapse’, even though it fell significantly less than the index. However, with a 163.6 percent (22.1 percent p.a.) net increase from 12 March, 2003 to end of 2007, it would have also provided the best participation. When evaluating this participation (61.5 percent of the recovery of the underlying index), one has to bear in mind that the exposure in variant 7 was at its minimum level of 30 percent on 12 March, 2003. From the end of 2003 to end of 2007, the participation rate increased almost to 100 percent, giving a net average annual return of 19.2 percent, 0.2 percent below the return of DAX®.

99

Dynagest SA Dynagest is a specialist in interest rate management and portfolio insurance.

Established in 1993, Dynagest is a jointstock company with a capital of CHF 1 million. Banque Cantonale Vaudoise, Lausanne, acquired 15 percent of the company’s share capital in 2005. Dynagest operates in two fields: fixed income advisory services and management, and quantitative management. It offers services to banks, pension funds, independent portfolio managers, insurance companies, foundations and high net worth individuals.

Dr René Sieber René is a founding manager of Dynagest and member of the Board of Directors. From 1987 to 1993 he worked for Banque Unigestion, Geneva, where he was responsible for macroeconomic analysis and fixed income investment strategy. He headed the Institutional Accounts Department from 1990 and was appointed assistant manager in 1991. He has been a lecturer in finance at the Geneva University since 1988 and has also taught at the Training Center for Investment Professionals, Switzerland (TCIP) since 1991. René holds a doctorate in economics from Geneva University and has been a Visiting Scholar at the Massachusetts Institute of Technology.

Contact rene.sieber@dynagest.ch

Sourcing profit from index derivatives Options on indexes and, in particular, options on the Dow Jones EURO STOXX® Indexes, are widely used by an extensive end-user client base that is now as varied in terms of assets under management as it is geographically diverse.

As a result, the index option market is recognised as one of the most liquid in the world, both in terms of bid/offer spread as well as volume.

The Dow Jones EURO STOXX® Index Options market also counts on an extensive network of marketmakers and other counterparties, which means that Eurex is able to ensure an excellent quality of price, even for the most exotic of options strategies and even in the most turbulent of market conditions, such as those experienced over the last 12 months.

OTCex Group Founded in 2000, OTCex is a leading global inter-dealer broker, offering intermediary services and analysis on the equity derivatives, money and interest-rate markets. The Group has a strong execution capacity in all listed derivatives, offers brokerage services on the complete OTC product range and serves institutional clients such as banks, market makers, asset managers, hedge funds and insurance companies.

Erwan Mahé Erwan is the head of macro-analysis and options strategy at HPC-OTCex. For more detailed information please visit www.otcexgroup.com.

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Implementing statistical arbitrage pairs trading with single stock futures Allianz Global Investorsâ&#x20AC;&#x2122; Dr Rainer Tafelmayer explains how single stock futures can be used to implement profitable pairs trading strategies

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T

he introduction of the UCITS III regime has opened up a raft of new opportunities for fund managers – particularly as far as derivatives-based long/short strategies such as 130/30 and pairs trading are concerned. In this report we will concentrate on pairs trading using single stock futures (SSF).

Pairs trading strategies have been employed by hedge funds since the mid1980s. The basic idea is quite simple: first you choose a pair of two related stocks and track their behaviour. If at a certain point in time there is a discrepancy in pricing between the two, you buy the stock that seems to be temporarily undervalued relative to the other and you sell the overvalued one.

When the mispricing has normalised, you unwind the position by trading in the opposite direction.

Thus pairs trading is a relative value strategy – and it is useful to note here a couple of its attractive features: • If one chooses the same initial notional amount for the two legs, the strategy is dollar-neutral and therefore self-financing.

• If one chooses pairs of stocks that have similar market beta, the strategy is market-neutral.

• If one selects the two legs from the same sector, the strategy is also sector-neutral.

The main challenge when implementing this strategy lies naturally in being able to identify suitable pairs of stocks. There are a variety of different approaches one can take, both on a fundamental basis and a quantitative basis. The quantitative strategies use advanced statistical methods for identifying pairs. We will now take a closer look at one of these ‘statistical arbitrage’ approaches.

Co-integration and mean reversion In our quantitative approach we are looking for pairs of stocks that exhibit a long-term

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Pairs trading strategies have been employed by hedge funds since the mid-1980s

relationship by using the concept of co-integration. Co-integration was first introduced in 1987 by Engle and Granger – the duo that went on to win the Nobel Memorial Prize in Economic Sciences for this and other work in 2003. It is now widely used for investigating relationships between time series in macroeconomics, as well as for security purposes in finance.

Murray (1994) has described co-integration as being like ‘a drunk and his dog on the way home from the bar’: although both exhibit a random behaviour in their individual paths, they never would depart too much from each other. Co-integration reveals common long-term stochastic trends and has to be distinguished from correlation, which is a short-term measure. It is also based on prices rather than returns, but high correlation of returns is neither sufficient nor necessary for high co-integration.

Co-integration is closely related to the concept of stationarity and mean reversion.

A time series is covariance-stationary if it has constant mean – constant variance and autocovariances depend only on the lag length. Then the time series exhibits mean reversion. Stock prices (or more precisely: the logarithms of stock prices) are almost always non-stationary, while their returns usually are.

Now, if for a pair of two stocks a linear combination of their log prices is stationary, the two stocks are said to be co-integrated.

Since we want to go short one of the stocks

and long the other we are interested in the special linear combination of the difference of the logs of the two time series s1t and s 2 t

y t = log( s1t ) − log( s 2t ) = log( s1t / s 2 t ) To find out whether this time series of the log price ratio is stationary (mean reverting) or not, a so-called unit root test has to be performed. In the literature, various stationarity tests have been proposed, among which the Dickey-Fuller test, the Phillips-Perron test, the KPSS test, and the Variance-Ratio test are the most popular (see eg, Hamilton (1994)).

In the Dickey-Fuller test, (and in its most simple form) the time series is modelled as AR(1), an autoregressive process of order 1:

y t = α ⋅ y t −1 + ε t where α is a constant and ε t is a disturbance term.

For α < 1 the process is mean reverting, whereas for α = 1 the process is a random walk, ie, not mean reverting. In this case, the process is said to have a unit root. (The case would lead to an exploding behaviour of the α > 1 time series and is not of relevance here.)

We can rewrite the process in the form

∆y t = y t − y t −1 = γ ⋅ y t −1 + ε t , where γ = α − 1 . We add lagged differences in order to take account of possible

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Figure 1: time series of stock prices

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Opening pairs trade

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Figure 2: time series showing the log price ratio

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Opening pairs trade 27

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Log price ratio

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autocorrelations in the residual ε t and add a constant ¼ for generality:

∆yt = ¼ + γ ⋅ y t −1 + β 1 ⋅ ∆y t −1 + ... + β n ⋅ ∆y t − n + ε t This is called the Augmented Dickey-Fuller test (ADF). Now we can formulate the hypothesis: H0: γ = 0 (non-stationary) against H1: γ < 0 (stationary).

To decide between the null hypothesis and the alternative hypothesis an estimated value γˆ can be obtained by multivariate OLS regression of the above equation.

For determining the confidence level the t statistic t = γˆ / SE (γˆ ) (SE standard error) is calculated. It can be shown that this t statistic is non-normal, but for

Upper Band

Closing pairs trade

large sample size it asymptotically approaches the Dickey-Fuller distribution.

This distribution can be obtained by MonteCarlo simulations and is tabulated in the literature. For a confidence level of eg, 99 percent the critical t-value is -3.43.

Figures 1 and 2 show a typical pattern for a pair of co-integrated stocks that tended to move together and deviate temporarily from the mean by more than, say, two standard deviations and revert back to the mean after some time. The first chart shows the normalised time series of the two stocks. The second chart shows the time series of the log price ratio of the two stocks, the moving average (MAV) and the Bollinger band of two standard deviations. A trading opportunity occurs each time the log price ratio leaves the Bollinger band.

If the stationarity analysis has shown that a pair of two stocks is co-integrated and thus qualifies for pairs trading, one then has to determine the exact conditions for opening and closing the position. Again there is a wide range of different solutions – but there is always a trade-off between the size of the spread (ie, the potential profit) and the number of positions. The wider the Bollinger band, the larger the initial spread, but the probability of crossing the band decreases at the same time.

Furthermore, a co-integration relation that existed in the past can of course break down in the future. This risk can be managed by defining the co-integration confidence level, the size of the position and by imposing stop

A co-integration relation that existed in the past can of course break down in the future

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losses and maximum holding periods.

The exact values of all these parameters have to be determined in extensive back tests that are subject to individual needs and risk budgets.

Implementing pairs trades using single stock futures Prior to the introduction of UCITS III, the main drawback for regulated funds using the pairs trading strategies came from the legal restrictions imposed on short selling stocks.

To implement a trade, funds were required to own the stock being shorted, and could only realise the short leg by reducing the weight of the stock. Obviously, only a limited number of possible pairs could be implemented in this way.

Under UCITS III, this constraint has been removed. Derivative instruments can be used to gain short exposure to stocks that the fund does not own, provided the fund holds other appropriate collateral. In the pairs trading context, these instruments should be delta-1 in order to replicate the stock price movement. Possible linear instruments are either over-the-counter (OTC) derivatives like equity swaps and contracts for difference (CFDs) or exchange-traded SSF. In all cases central prerequisites are liquidity and availability, but SSF have particular advantages of listed SSF owing to the exchange’s central counterparty reducing credit risk and published daily closing prices introducing greater transparency.

The exchange always acts as the central counterparty, but in most cases, SSF are directly negotiated and crossed with the broker as block trades. In this way the liquidity is created on demand. Hence, the liquidity of the future is essentially the liquidity of the underlying stock and its availability for lending.

Since 2005 the number of European SSF listed on Eurex has grown from 89 to approximately 600. Eurex now nearly covers the complete Dow Jones STOXX® 600 Index.

This constitutes a very reasonable number for pairs trading – indeed, a universe of: N = 600 stocks leads to a total of: N(N-1)/2 = 179,700 possible pairs. If one restricts the legs of a pair to be members of the same ICB industry there would still be approximately 27,000 possible pairs.

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The exchange always acts as the central counterparty, but in most cases, SSF are directly negotiated and crossed with the broker as block trades In summary it can be concluded that pairs trading is an attractive long/short strategy – not only for hedge funds, but also for regulated funds prohibited from direct short selling. With the extended use of derivatives under UCITS III and the development of the SSF market universe, long/short equity strategies can now be fully exploited. SSF are powerful linear instruments with which to implement these strategies in a regulated exchange environment.

Allianz Global Investors Allianz Global Investors is one of the top-five asset management companies worldwide, with about EUR 1 trillion of assets under management. Allianz Global Investors offers the whole range of products covering all major equity and fixed income investment styles and providing balanced products as well as alternative investment solutions. The business is organised on two global lines: fixed income and equities, with Pimco serving as the global investment platform for fixed income and RCM for equities.

Dr Rainer Tafelmayer Dr Tafelmayer is an equity portfolio manager in the RCM systematic division of Allianz Global Investors. He joined the company in 2002, having previously worked consulting companies on finance and risk management for several years. He holds a PhD in physics from the University of Heidelberg.

Contact Rainer.Tafelmayer@de.rcm.com Tel: + 49 69 263 83863

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Equity options and cash markets Merrill Lynchâ&#x20AC;&#x2122;s Lars Nackter and Rajdeep Patgiri showcase what options reveal about cash market behaviour

E

arnings announcements can have a significant impact on the return volatility of companies at the time of release. The equity options market largely anticipates this behaviour. From the pricing of options, one can infer the magnitude of the anticipated price change for companies that are expected to report earnings.

From the pricing of equity options listed on Eurex, it is possible to derive an estimate of the marketâ&#x20AC;&#x2122;s expectation of volatility over the duration of two option contracts. The behaviour of realised volatility around the time of earnings announcements is widely anticipated by option market participants.

Consequently, the option-implied volatility forecasts are generally higher when an earnings announcement date falls within the duration of a contract. Shorter dated options are typically impacted the most, as the earnings release is expected to have a larger impact on the average daily volatility. Using

the degree to which first month options have a higher implied volatility than second month options, one can back-out a marketimplied estimate of the expected earningsrelated price move. Should the implied volatility of the first and second month contracts be equal, the model would expect a zero earnings-related price change.

The price impact model assumes that the first month implied volatility is higher than that for the second month, solely because of the upcoming earnings release. However, such a situation could arise because of the expectation of other events that may impact the return volatility of a stock over the duration of the first month option contract.

Hence this type of analysis is not appropriate in all circumstances.

Using the at-the-money implied volatility at mid-market prices of first and second month contracts, the current expectation of what the volatility of the second month contract will be next month is calculated, ie, the forward (one-month) volatility. The model assumes that the forward volatility is the market's expectation of risk over the first month contract with the exception of

the instance when earnings are reported.

The difference between the first month and the forward volatility is the model expectation of the instantaneous volatility that will result from the earnings release. This measure, in turn, is used to calculate the expected price change.

Formally, let and denote the annualised option implied volatility of the first and second month contracts, respectively, and and denote the corresponding times to expiration in years. The annualised forward volatility, , , over to equals

The non-annualised volatility that is expected to result from the earnings announcement, , is assumed to equal the difference between the contributions from first month volatility and the forward volatility, and is calculated as:

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Assuming that continuously compounded (ie, log) returns are normally distributed, the expected absolute value of returns resulting from the announcement equals:

Below is the forecasted price impact of a sample of European companies that recently reported quarterly earnings. On every Monday during the earnings season, we run an analysis for the companies that are expected to report during that particular week. All volatilities are measured on the preceding Friday, consequently, the data shown for Credit Suisse, which reported earnings on Thursday, 24 April, is as of Friday, 18 April.

Table 1 lists the earnings report date and times for each stock, as well as the optionimplied magnitude of the price return that was anticipated as a result of the earnings release. Note that the model can be used to forecast the magnitude of the price impact, but does not provide any insight into the direction of the price move. In fact, looking across the 25 European companies with liquid options markets that reported earnings in the three weeks ending 9 May on which the model predicted a non-zero price impact, we find that the median absolute forecasting error was 80bps. If the absolute difference were zero, this would imply that options market participants were fully capable of predicting the market.

For instance, the pricing of options on Credit Suisse suggested a stock move of 2.8 percent in either direction as a result of the 24 April earnings release. The instantaneous (within the next couple of minutes) stock move following the earnings announcement was +2.7 percent. Similarly, UniCredit opened 2.9 percent down following its 8 May earnings announcement when the options market predicted a 2.7 percent move.

Price behaviour during option expiry week Open interest information from the index options market can provide useful insight into the behaviour of the underlying index during the expiry week when option market makers most actively hedge. This article describes the ‘pin risk’ arising from open interest imbalances on the Eurex Dow Jones EURO STOXX 50® Index, and provides historical analysis indicating a positive relationship between these imbalances and cash market returns in the week to expiry.

A large imbalance between the open interest on call and put options for strikes near the spot level may lead to pin risk as expiry approaches. Pin risk refers to the situation in which an option underlier closes (or is ‘pinned’) at or near the strike at expiry.

In such a situation, the writer of the option is unable to predict with certainty whether the option will be exercised or not prior to the expiry, and may end up with a residual position in the underlying. This residual

position can result in a meaningful loss to the writer if the underlying price moves sharply against him. Therefore, option writers should be aware of pin risk and may need to increase the frequency of deltahedging closer to expiry to reduce this risk.

Assuming option users (ie, investors instead of option market makers) buy puts and sell calls, and option market makers delta-hedge their positions, the latter will be long gamma when the open interest imbalance is towards calls and short gamma when the imbalance is towards puts. In a long gamma position, delta-hedging would lead market makers to buy the underlying when it trades below the strike and sell the underlying when it trades above. At or near expiry, the resulting buying or selling pressure on the underlying can be so substantial, especially when the option imbalances are large relative to the liquidity of the underlying, that the closing price is pinned on the strike.

Chart 1 shows the distribution of call versus put imbalances in a number of contracts for Eurex-listed options on the Dow Jones EURO STOXX 50® Index for the 18 April, 2008 expiry as of 11 April, 2008 (one week prior to expiry). The index stood at 3,700 on the 11 April, while a large imbalance in favour of calls was recorded at the 3,800 strike. The 3,800 strike represented pin risk for the index as deltahedging by market makers would likely push and pin the index at this level closer to

Table 1: price impact of earnings releases implied by Eurex-listed equity options Exported earnings report Ticker CSGN VX TLSN SS DAI GY SAN FP SAP GY DB1 GY SCMN VX AGN NA UNA NA MUV2 GY UCG IM TIT IM

Name Credit Suisse Group TeliaSonera AB Daimler AG Sanofi-Aventis SAP AG Deutsche Boerse AG Swisscom AG Aegon NV Unilever NV Muenchener Rueckver AG UniCredit SPA Telecom Italia SPA

Date 24 Apr 25 Apr 29 Apr 30 Apr 30 Apr 06 May 07 May 07 May 08 May 08 May 08 May 09 May

Time (local) 19:00 07.:30 12:30 Bef-mkt Bef-mkt Aft-mkt 07:30 Bef-mkt 07:00 09:00 Bef-mkt 14:00

Options-implied price impact 1st mnth i-vol 36.8% 38.2% 29.3% 26.2% 31.4% 41.3% 25.5% 32.4% 27.2% 22.1% 26.2% 34.2%

2nd mnth i-vol 35.6% 36.0% 26.9% 25.9% 27.4% 39.8% 21.5% 28.3% 22.8% 20.6% 21.6% 32.8%

Expected return (+/-) 2.8% 3.8% 2.8% 1.0% 3.7% 2.0% 2.5% 2.9% 2.7% 1.5% 2.7% 1.8%

Subsequent Realised Actual return 2.7% 4.2% -3.3 % 0.9% 5.0% 3.0% -2.1% -2.5% 3.5% -1.3% -2.9% 1.8%

Source: Eurex and Merrill Lynch Equity Derivatives Strategy. Implied volatilities were sourced on the close of the Friday preceding the earnings announcement The model estimates price moves on the instant that the earnings results are released, not the price moves that are expected over the entire day

Absolute difference 0.1% 0.4% 0.5% 0.1% 1.3% 1.0% 0.4% 0.4% 0.8% 0.2% 0.2% 0.0%

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expiry. Indeed, the index closed at 3,809 on the day of the expiry.

Measuring the outstanding call and put notional amounts adjusted by the option delta can provide insight into the behaviour of the underlying market as expiry approaches.

The imbalance between the call and put delta-adjusted notional is a measure of the amount of the underlying that may be traded by option market makers. The delta-adjusted imbalance on the Dow Jones EURO STOXX 50® Index varied substantially since January 2006. While the imbalance was on average

towards calls prior to the start of the credit crisis in July 2007, it has turned towards puts since then. The market return in the week to expiry appears to be positively correlated to the imbalance measured one week prior to expiry, as shown in chart 2. Historical analysis using data since January 2006 shows that the relationship is stronger when the open interest imbalance is greater than EUR 10 billion in favour of calls.

December 2006 expiry saw the largest imbalance in favour of calls at EUR 57.8 billion, representing 114 percent of the average daily futures volume of the index.

Chart 1: distribution of call-put open interest imbalance in number of contracts for Eurex-listed options on the Dow Jones EURO STOXX 50® Index (April 2008 expiry, as of 11 April, 2008) 150

100

Significant call imbalance existed at strike 3,800.

Active delta-hedging by option market makers led the index near this level on the week of the expiry

Number of contracts (in 000’s)

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The index returned 2.5 percent in the week to expiry. On the other hand, the March 2008 expiry saw the largest imbalance in favour of puts at EUR 72.5 billion and the index returned – 1.7 percent in the week to expiry.

Merrill Lynch Merrill Lynch is one of the world's leading wealth management, capital markets and advisory companies, with offices in 40 countries and territories and total client assets of almost USD 2 trillion. As an investment bank, it is a leading global trader and underwriter of securities and derivatives across a broad range of asset classes and serves as a strategic adviser to corporations, governments, institutions and individuals worldwide. Merrill Lynch owns approximately half of BlackRock, one of the world's largest publicly traded investment management companies, with more than USD 1 trillion in assets under management.

For more information on Merrill Lynch, please visit www.ml.com

0

18 Apr 08 close = 3,809 -50

11 Apr 08 close = 3,700 -100

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Chart 2: performance of the Dow Jones EURO STOXX 50® Index in the week to expiry against delta-adjusted open interest imbalance of Eurex-listed options (January 2006 until April, 2008) 6%

Returns vs. all imbalances 4%

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y = 0.0003x R2 = 0.1931

Returns vs. imbalances in excess of EUR 10Bn Dec 06

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A call-put imbalance one week prior to expiration greater than Euro 10 Bn appears to give rise to positive weekly SX5E returns on the week to expiration

y = 0.0002x R2 = 0.0544 -4% Jan 08 -6%

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Authors Lars Nackter and Rajdeep Patgiri are research analysts at Merrill Lynch’s equity derivatives strategy team for Europe, the Middle East and Africa. The equity derivatives strategy group consists of 16 analysts in New York, London, Hong Kong and Tokyo. In addition to providing research on the uses of options, futures, and exchange traded funds, the team focuses on developing financial engineering solutions that allow investors to generate alpha, efficiently manage their risk/return profiles, and gain exposure to themes or related asset classes such as volatility or hedge funds.

Lars has an MSc in theoretical physics from Imperial College London. In his dissertation he focused on applying stochastic calculus to quantum mechanics. Rajdeep has a PhD in finance from INSEAD; his dissertation focused on mutual funds’ performance analysis.

Contacts lars_nackter@ml.com Tel: + 44 (0) 207 996 5530 rajdeep_patgiri@ml.com Tel: + 44 (0) 207 996 1635

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Extracting value from volatility Crédit Agricole Asset Management Group’s Eric Hermitte and Gilbert Keskin demonstrate how investors can use listed instruments to extract value from volatility

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nvestors have traditionally considered volatility negatively, owing to its association with falling markets. When markets are rising, analysts and investors are less likely to change their minds – and much less so on a daily basis. By contrast, when things take a turn for the worse, investors tend to get nervous and the consensus view begins to diverge. As a result, markets start to fluctuate more widely and investors looking for downside protection will buy put options without paying attention to volatility levels – thus uncertainty breeds volatility.

As well as being a useful risk indicator, volatility can, however, also be used to generate returns and should be considered as an asset class in its own right. Indeed, the

de-correlation between the behaviour of equity volatility, realised as well as implied, and that of equity returns and credit spreads has been proven. Therefore, introducing volatility into an equity or balanced portfolio makes it possible to reduce overall risk while increasing expected return – most notably during times of low volatility.

The implied volatility of securities, which reflects the risk expected by investors, can be isolated and traded through derivative instruments. Listed index options, such as those on Eurex, offer a useful and liquid means of implementing this strategy. As the price of options varies according to implied volatility, options can also be used

Volatility can also be used to generate returns and should be considered as an asset class in its own right

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in such a way as to isolate the implied volatility exposure, by hedging the other risks through appropriate instruments such as futures.

Another way to consider volatility as an asset class is by looking at the return investors can generate through volatility.

By constructing strategies on the volatility of an underlying security, investors can also enhance portfolio performance. There are two different ways of investing in volatility to this end.

Arbitrage, an absolute return approach, relies mainly on the arbitrage of volatility between different underlying securities (single stocks, equity indexes…) either within a single asset class, or between different asset classes (equity volatility against credit spreads).

A familiar example, implemented by many hedge funds, is the convertible bond volatility arbitrage strategy. The objective of this strategy is to detect, for the same underlying asset, any excessive spread between the volatility priced in the convertible bond and the volatility being priced in the option market for the same maturity and exercise price. Up until 2004, it was relatively easy to find discounts in convertible bond volatility, although the

Another way to consider volatility as an asset class is by looking at the return investors can generate through volatility lack of issuance in the European market has meant that in certain cases, volatility premia have risen.

Unlike other asset classes, volatility generally reverts to the mean, however, another type of arbitrage can be used to exploit this phenomenon. During market turmoil, the volatility structure of an equity index, such as the Dow Jones EURO STOXX 50® Index, can be temporarily inverted. A flattening strategy can be implemented in cases of strong inversion by selling shortterm implied volatility, and buying the

medium-term volatility of the index.

The directional approach is based on the medium-term structural trends in volatility: equity volatility fluctuated significantly and with excessively high levels between 2001 and 2003 (30 percent to 40 percent for the one-year implied volatility of the Dow Jones EURO STOXX 50® Index) and historically low levels between 2005 and 2006 (12 percent to 15 percent). The best way to benefit from the change in a volatility regime is to run a structurally long position on low volatility levels, due to the pro-

Figure 1: one-year implied volatility of the Dow Jones EURO STOXX 50® Index

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Source: CAAM

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tection this offers investors in times of crisis. This protection is less efficient when volatility is high. For high volatility levels, it would appear to be more profitable to run a structural short position on implied volatility. This process can therefore be described as a meanreversion strategy.

To apply this directional approach, first one must select the volatility in which to invest. In terms of liquidity, index options are clearly more accessible than individual names. The second step is to select the maturity that offers the best protection in times of crisis but that does not incur considerable costs in calm market conditions. One-year implied volatility represents the medium-term structural volatility of the equity market better than short-term volatility indexes (one to three months) and has also significantly less time value (‘Theta’). Moreover, a pure tracker could be managed on this oneyear maturity without negative carry, which is very difficult to achieve on shortterm maturities and on less liquid longerterm maturities.

Finally, it is crucial to select a process that will not only act as a shock absorber, but also crystallise some performance on a long-term horizon by benefiting from the structural changes in the volatility environment. Implementing a strategy to exploit the regression of volatility to its historical mean (around 25 percent) represents a genuine opportunity to do this.

For European equities and, more particularly, for the Dow Jones EURO STOXX 50® Index, the long-term average is in the range of 22 percent to 25 percent. This

means that when volatility is lower than this average, the strategy consists of having positive exposure to this implied volatility; when it is over 25 percent, the reverse is applied.

How does one implement this strategy?

By buying and selling options with an average maturity of one year. The underlying equity risk and the residual interest rate risk are systematically hedged. This strategy can also be applied on a global investment universe using the benchmark stock indexes. By actively managing the exposure to this one-year implied volatility, it is possible to supplement the performance of this long-term trend by means of a mechanism that exploits short-term fluctuations in volatility.

The recent market crisis has considerably increased the demand for such strategies, while fresh interest has built up for strategies using correlation or options on volatility. The explosive growth of the derivatives market, and the increasing number of funds invested now actively playing on volatility have made this new asset class truly attractive. Indeed, more and more investors are adding volatility to their portfolios having observed that when they are used in a directional way or in arbitrage strategies, volatility-based strategies have the advantage of outperforming others in times of market uncertainty. Today, the largest market is in equity volatility, but we should not discount that in the future, volatility markets will also emerge in other asset classes, such as commodities, emerging markets, currencies or credit.

The increasing number of funds invested now actively playing on volatility have made this new asset class truly attractive

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Crédit Agricole Asset Management Group Crédit Agricole Asset Management Group is Crédit Agricole Group’s asset management arm.

With a total of EUR 508.2 billion of assets under management as at 31 December, 2007, CAAM Group is the fifth-largest asset manager in Continental Europe. It is also ranked no.1 in Europe and no.1 in France in mutual funds. It has more than 2,336 employees, including 677 investment professionals dedicated to portfolio management. CAAM Group’s subsidiaries offer a complete line of investment products for the regional banking networks of Crédit Agricole, Le Crédit Lyonnais (LCL) and the international retail banking subsidiaries of Crédit Agricole group, as well as for institutional investors, large corporate accounts and third-party distributors in France and abroad. CAAM Group is active in more than 20 countries across Europe, Asia-Pacific, North America, the Middle East and North Africa.

Gilbert Keskin Gilbert Keskin is the co-head of volatility, arbitrage and convertible bonds and a portfolio manager in the volatility, arbitrages and convertible bonds team at CAAM. He joined CAAM’s research department in 2000 after completing his studies on the development of investment tools. He then participated in a collateralised debt obligation development project in 2001, before joining the team as a convertible bond manager.

Gilbert graduated from ENSIMAG, a French engineering school, in applied mathematics and computer science.

Eric Hermitte Eric has been co-head of volatility, arbitrages and convertible bonds at CAAM since 2006.

He joined the firm in 1998 as a portfolio manager in the structured products management team. In 2002 he joined the convertible bond team to focus on convertible bond management. Prior to CAAM, he worked as an options trader at Dresdner Bank for four years. Eric holds a postgraduate degree in economics and a postgraduate degree in banking and finance from the University of Paris Panthéon Sorbonne.

Contacts Gilbert.Keskin@caam.com Eric.Hermitte@caam.com

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Volatility – the perfect asset class for the equity fund manager Eurex’s Byron Baldwin and Alexey Weizmann explain why volatility index futures are an attractive asset class for equity fund managers owing to their negative correlation to equity markets, and show how they can be used to increase portfolio diversification and raise returns

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olatility, expressed notionally as , is a measure of the uncertainty of the returns provided by an asset, also known statistically as standard deviation of the returns. Volatility thus acts as a measure of the probable distribution of the future returns of any given investment. The higher the standard deviation (ie, the higher the volatility), the greater the probability and expectation of higher and lower returns.

There are several types of volatility, including historical, implied and realised.

Historical volatility measures the level of

volatility over a given time period. Implied volatility is the volatility implied by the option price given other variables such as time, strike price, underlying asset price, etc. Realised volatility measures the magnitude of the subsequent movement in the asset following a transaction.

Implied volatility can be calculated iteratively using the Newton-Raphson technique. A typical phenomenon, known as the implied volatility smile, reflects that options with different strikes but identical expiration dates trade at different implied volatilities. Varying the expirations, we can build a surface of volatilities, which is referred to as the volatility term structure.

Volatility has always been regarded as a

reflection of market participants’ expectations and a ‘lead indicator’ of impending moves in the underlying asset. Figure 1 depicts how the Eurex VSTOXX® Index moved sharply upwards ahead of the recent financial market crisis.

The relationship between equity volatility and equity markets The basis of the attraction of volatility as an asset class to the equity fund manager lies in the negative correlation of equity volatility to the equity market. The causality between equity market and equity volatility can be attributed to the ‘leverage effect’: a fall in equity prices increases a company’s leverage, thereby increasing the risk to

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Figure 1: Eurex Volatility Index Futures – the ‘fear gauge’ of the European financial markets 35 33 31

VSTOXX® implied volatility

29 27 25 23

Bear Stearns announces that it will provide $3.2bn to bail out one of its hedge funds, High Grade Structured Credit Strategies Fund

21 19 17 15 1.6.07

8.6.07

15.6.07

22.6.07

29.6.07

6.7.07

13.7.07

20.7.07

27.7.07

3.8.07

10.8.07

17.8.07

24.8.07

31.8.07

7.9.07

VSTOXX ®

Source: Eurex

equity holders and increasing equity volatility. In Options, Futures & Other Derivatives, John C. Hull explains the causality between equity prices and equity volatility: “As a company’s equity declines in value, the company’s leverage increases.

This means that the equity becomes more risky and its volatility increases. As a company’s equity increases in value, leverage decreases. The equity then becomes less risky and its volatility decreases. This argument shows that we can expect the volatility of equity to be a decreasing function of price.”

Eurex Volatility Futures The Eurex Volatility Futures contracts on VSTOXX®, VDAX-NEW® and VSMI® represent the implied volatility level on three different underlying equity index options, the Dow Jones EURO STOXX 50® Index, DAX® and SMI® respectively.

The implied volatility levels of the Eurex Volatility Futures contracts take into consideration the volatility smile as well as the skew and correspond to the square root of implied variance that is (in fact, Eurex Volatility Index Futures are 100 percent x for the quote to reflect volatility in percentage terms) to bring the quotation close to that used to evaluate variance in the over-

the-counter (OTC) variance swap market.

The formula for the computation of the volatility index is not based on a particular options pricing model like Black-ScholesMerton. The index contracts make volatility more tradable as an asset, since changes in the value of the contracts arise solely from changes in volatility and are unpolluted by changes in the underlying equity market. For instance, if one VSTOXX® Future was bought at 14.00 (percent) and sold at 16.00 (percent) then the payoff would be the index multiplier times the difference between the two volatilities that is EUR 1,000 x (16-14) = EUR 2,000 – a straightforward linear payoff linked to the change in volatility.

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The payoff of a Eurex Volatility Index Futures contract can be expressed as: Payoff (volatility index) = index multiplier (ie, EUR 1,000 or CHF 1,000) x (realised 30-day implied volatility level at expiration – expected 30-day implied volatility at trade initiation) x number of contracts.

If an investor bought a EUR 5 million position (ie, 100 contracts) in VSTOXX® Volatility Index Futures struck at an expected implied volatility of 50 percent with an eventual implied volatility at maturity of 70 percent, his payoff would be EUR 1,000 x (70 percent - 50 percent) x 100 = EUR 2,000,000.

Alternatively, if implied volatility fell to 30 percent, the investor’s loss would be EUR 1,000 x (50 percent - 30 percent) = EUR 2,000,000. The payoff is linear – thus a Eurex Volatility Index Future can be likened to that of a forward on 30-day (implied) volatility and it can be compared to that of a volatility swap.

Fund management applications of Eurex Volatility Index Futures The negative correlation of equity volatility to the underlying equity market makes equity volatility an attractive asset to incorporate within an equity portfolio to increase portfolio diversification and potentially enhance portfolio returns.

The following analysis shows the effects of incorporating equity volatility into an equity portfolio. In this instance we have

Volatility has always been regarded as a reflection of market participants’ expectations

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The negative correlation makes equity volatility an attractive asset to increase an equity portfolio’s diversification and potentially enhance return taken the Dow Jones EURO STOXX 50® Index Future as the ‘core’ equity index portfolio and combined it with VSTOXX® Volatility Future. It was found that under the period of analysis from 1 December, 2005 to 25 July, 2008, the optimum combination of Dow Jones EURO STOXX 50® Index Futures and VSTOXX® Futures was 70 percent: 30 percent rebalancing weekly (the analysis also found that rebalancing on Wednesdays generated the highest return). Figure 2 looks at the returns of the two portfolios.

Managing tracking error and rebalancing costs Benchmark or passive index equity fund managers are, in essence, short volatility. As equity markets become more volatile, tracking error and rebalancing costs increase. Equity fund managers can go long Eurex Volatility Index Futures to hedge against increases in portfolio tracking error and reduce the rebalancing costs of their

benchmark/passive index funds.

Similarly, convertible bond arbitrage fund managers can use Eurex Volatility Index Futures to hedge their embedded volatility exposure. Periods of low dispersion and high correlation across equities make it difficult for fund managers to extract alpha in stock selection. However, by buying Eurex Volatility Index Futures, they can hedge out low dispersion and high correlation risk.

Because of their negative correlation to equity markets, the Eurex Volatility Index Futures contracts offer a very efficient means for equity fund managers to increase portfolio diversification. Since there is no requirement to delta hedge for movement in the underlying asset, Eurex Volatility Index Futures contracts provide a very economic means of initiating directional volatility strategies. They also offer leveraged exposure to volatility (ie, initial margin), and thus are an ideal tool for buying and selling volatility and generating

Figure 2: a 100 percent Dow Jones EURO STOXX 50® Index Futures portfolio compared with a combined 70 percent Dow Jones EURO STOXX 50® Index / 30 percent VSTOXX® Index portfolio

alpha returns. This can be done either in isolation, or in combination with other Eurex futures products, to initiate a variety of relative value/cross asset class strategies.

Moreover, as exchange traded derivative products, Eurex Volatility Index Futures offer the added benefit over their OTC counterparts in terms of mark-to-market, independent valuation and substantially reduced counterparty risk due to the use of Eurex Clearing AG as central clearing house.

As Emmanuel Bourdeix, head of derivatives and convertibles, Crédit Agricole Asset Management, said in the Financial Times: “Volatility should be considered as an equity sector in its own right alongside financials, industrials and mining stocks.”

Byron Baldwin Byron is a member of the institutional investor business development team at Eurex in London. Byron has more than 25 years’ experience in exchange derivatives products advising central banks, hedge funds, traditional fund managers and multinational corporations. Byron read monetary economics at the London School of Economics for his undergraduate degree and finance at the University of Leicester Management Centre for his Masters degree.

Alexey Weizmann Alexey joined Eurex product strategy in 2007 after graduating in financial mathematics at the Goethe University in Frankfurt.

Among other things, he is product manager, responsible for volatility derivatives at Eurex in Frankfurt.

Source: Eurex

Contacts byron.baldwin@eurexchange.com alexey.weizmann@eurexchange.com

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Sector strategies Sector derivatives allow market participants to gain exposure to specific market or industry sectors. Deutsche Bankâ&#x20AC;&#x2122;s Pamela Finelli and Mathew Howe investigate how they can be incorporated into an equity portfolio

S

ector derivatives can be used as part of a strategic asset allocation process, to take outright views, or to hedge existing exposures.

But while sector products make it possible to take a pure directional view on a market or a sector, the strategies can also be market neutral.

For instance, letâ&#x20AC;&#x2122;s assume that an investor has an overweight position in the banking sector. He or she may believe that the sector has been oversold and that the

market has overestimated write-downs. The same investor may also think that the outperforming basic resources sector is due for a sell-off, believing that the market is pricing in more consolidation, due to an expected worldwide easing in commodity prices. In both cases, such views can be successfully expressed through sectorbased strategies â&#x20AC;&#x201C; irrespective of overall market moves.

This kind of exposure can be obtained by taking a direct investment into a representative basket of sector stocks; establishing a position in a sector future; trading an over-the-counter (OTC) deriv-

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Figure 1: product comparison Product

Stocks

Futures

Swaps

Certificates

ETFs

Classification

Shares

Derivatives

Derivatives

Security

Fund

Annual/ongoing

Custody

Clearing

Financing spread

Management fee

Management fee

Margin requirements

None

Daily margin adjustment

Collateral required None

None

Short exposure

Yes

Yes

Yes

Generally long

Yes

Borrow/lending

Yes

N/A

No

Yes

Credit risk

Issuer

Counterparty

Issuer

Fund

Market makers

Generally more than More than one one market maker market maker

Counterparty

Issuer

More than one market maker

Dividend/coupon

Paid

None

Paid

Re-invested or paid

Re-invested or paid

Price availability

Screen

Screen

Live/Phone

Live/Phone

Screen

Index tracking

N/A

Can trade rich/ Cheap to fair value

Yes

Yes

Yes

Indexes/sectors tracked

N/A

STOXX/Other

Most

Most

Various

Tracking error

N/A

Varies

None

None

Varies (from zero)

Maturities (liquid)

N/A

1m to 3m

0y to 3y

3m to 5y

No maturity

Redeemable/EFP

N/A

Yes

No

No

Yes

ative such as a swap or a forward; buying (or selling) an exchange traded fund (ETF), or by investing in a securitised product.

In this paper, we examine and compare these instruments. We also explore how derivatives may be used in practice to implement a specific market view on sector performance.

Sector derivative â&#x20AC;&#x2DC;wrappingsâ&#x20AC;&#x2122; offer numerous advantages over holding underlying shares. These derivatives can help reduce tracking errors. Sector indexes are continuously rebalanced, while holding the underlying shares in an attempt to track an index leaves investors at the mercy of actively trading to maintain a perfect portfolio composition. It will inevitably be easier to hold one product rather than, say, 30 different single stocks that may comprise a sector index. This is particularly true if your infrastructure or IT platform is operationally restricted.

Sector derivatives also give the investor the opportunity to gain complete market access, which otherwise might not be pos-

Local Clearing House

Sector derivatives give the investor the opportunity to gain complete market access, which otherwise might not be possible

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sible. For example, an investor seeking to short the Dow Jones EURO STOXX® Banks sector could easily sell the sector futures contract for the desired exposure. To replicate the perfect short sector position via selling the individual shares, one might have to short sell Greek and Icelandic stocks, a strategy that would be complicated by regulation and potential liquidity constraints.

Sector derivatives may provide outperformance versus a stock basket through dividend yield enhancement, as well as better stock borrow inventory values. Holding an underlying stock not only leaves you with the responsibility of maintaining the perfect basket, but also puts you on the receiving end of withholding taxes, as well as with the task of distributing your stock into the stock borrow market.

There are numerous types of derivatives that can be used for sector exposure. Figure 1 compares the characteristics of various instruments that allow a holder to gain exposure to a market sector.

• Futures contracts are listed derivatives over the price return index. Perhaps the most common sector futures are the Eurex-listed contracts for each of the 19 Dow Jones EURO STOXX® Sector Indexes.

Futures are available on both the EURdenominated sector indexes as well as on the pan-Euro underlying indexes. All of the Eurex Dow Jones EURO STOXX® Futures are denominated and hence composite into euros.

The contracts expire quarterly. Unlike OTC products, futures are cleared through independent clearing houses. Sector futures are gaining in popularity.

• Options are also listed on Eurex for the Dow Jones EURO STOXX® Sector Indexes and can be used for speculation, yield enhancement, or hedging purposes.

Options can be an appealing choice for investors who seek leveraged exposure to a sector, or have a directional view on a sector with a set time horizon.

• Over-the-counter (OTC) sector swaps are fully leveraged products that provide long or short exposure to sectors. In a long swap, the client pays a fixed rate (say Libor), and receives sector performance in return. In addition, he has the option to receive dividends and pays a financing charge plus a spread on the

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Selecting the perfect sector strategy can be challenging, as each product has its own advantages and disadvantages

notional investment amount.

Swaps can be written on either an open basis, through which the client can trade in and out of the position as and when they choose, or on a term and a structured reset basis. Term trades benefit from tighter spreads, but at the cost of reduced flexibility.

• Exchange traded funds (ETFs) are passively managed investment funds that track the performance of an underlying index, in this case, a sector index. You can do almost anything with an ETF that you can do with a single share or stock.

The instruments combine the advantages of stocks (tradability and liquidity) with index funds (diversification and regulated infrastructure) in a single product. They are ideal for both institutional investors, as well as for small retail investors that want to receive benchmark performance.

• Certificates are similar to ETFs, in that they are fully funded instruments issued by banks or broker-dealers such as Deutsche Bank. They provide mostly long

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exposure, are often exchange-listed and hence, can be traded without OTC derivatives documentation. As certificates are issued by a single broker-dealer, the endinvestor will have exposure to the issuer’s credit.

Selecting the perfect sector strategy can be challenging, as each product has its own advantages and disadvantages. In certain cases, there is a range of possible solutions, and no clear-cut choice that is right for every situation.

The table below outlines scenarios in which these different instruments would be most applicable.

As certificates are issued by a single broker-dealer, the end-investor will have exposure to the issuer’s credit

Here, we show two examples of sector derivatives usage in practice: Tilting asset allocation An asset manager with a broad (Dow Jones STOXX®) benchmarked portfolio thinks commodities will outperform and retail stocks will underperform.

The decision is to tilt the portfolio by adding a long short futures overlay.

• Overweight 5 percent basic resources (SXPP) • Overweight 5 percent energy (SXEP) • Underweight 5 percent retail (SXRP)

• Underweight 5 percent market (SX5P) as proxy to broad benchmark).

This strategy can easily be implemented by taking long/short positions in the relevant

futures contracts. Because it is a relatively short-term view, roll risk and perfect tracking is not an issue. Rather, flexibility, ease of clearing and settlement (as futures are already used) and liquidity are most

Scenario

Instrument

Rationale for choice

Retail investor with a view about a sector

ETF

Low transaction costs. Can trade in small size via retail broker

Portfolio manager implementing a shortterm asset allocation strategy

Futures, swap

Allows long and short exposure. Low transaction costs. Liquidity

Portfolio manager taking a long-term view. Concerned with tracking error

Swap, certificate, note

Futures require quarterly rolls. OTC instruments carry a guaranteed payoff

Hedge fund wanting maximum leverage

Futures, swap, options

Swaps will require margin to be lodged with counterparty. Futures margin is lodged with the exchange

Asset manager with low tolerance for credit risk/counterparty exposure

Futures, ETF

Futures are cleared by third party clearing houses. ETFs will have an underlying asset base

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important. There are a number of counterparties who will make a market and facilitate the required liquidity to implement this strategy.

Protecting against short-term uncertainty A hedge fund has a positive outlook on the banking sector and holds a sizeable position in bank shares. The manager's fundamental view on the stocks he holds is positive, but he fears that macro issues could trigger a short-term decline in the sector. He does not want to miss out on any long-term potential upside movement and thus is keen to maintain his holdings. Instead, he decides to purchase a put option on the Dow Jones EURO STOXX® Bank Index to protect his long position over the period of uncertainty.

The sector index option should provide a hedge against downside movements below the put strike, is a limited risk strategy and allows the investor to keep any stock appreciation (less the option premium paid). If the put finishes out-of-the-money at expiry, then the up-front premium paid will be lost, but in the event that the sector does experience a broad decline, the hedge should cushion against losses.

Deutsche Bank Deutsche Bank is a global investment bank with a strong and profitable private clients franchise. A leader in Germany and Europe, the bank is expanding in North America, Asia and key emerging markets. Within Deutsche Bank, the global markets division

is responsible for the origination, sale, structuring and trading of fixed income, equity, commodity, foreign exchange, derivative and money market products.

Deutsche’s equity derivatives group is a leading provider of investment and risk management solutions. The award-winning platform offers a broad spectrum of marketdriven products, including exchange traded and OTC vanilla derivatives, as well as synthetic and complex equity derivatives to a wide array of institutions, hedge funds, corporates and retail clients.

Pamela Finelli Pamela is Deutsche Bank’s European head of equity options strategy. For the past nine years she has been part of Deutsche’s equity derivatives strategy team, which provides in-depth analysis and research on equity options, volatility, correlation and dividends. Pamela is also one of the lead architects for the team’s award-winning equity derivatives website, ederivatives.db.com. Pamela holds a BS degree in business from Pennsylvania State University in the US. Mathew Howe Mathew is an equity derivatives trader at Deutsche Bank, specialising in European sector TRS and basis trading. He forms part of the Equity Derivatives delta-1 platform and has a Masters degree in mechanical engineering from Imperial College.

Contacts pam.finelli@db.com mathew.howe@db.com

In the event that the sector does experience a broad decline, the hedge should cushion against losses

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Gaining credit exposure through equity options â&#x20AC;&#x201C; balancing portfolios Union PanAgora Asset Managementâ&#x20AC;&#x2122;s Dr Harald Henke and Helmut Paulus explain why equity investors should consider taking on credit exposure and how they can do so using put options

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I

nstitutional investors will often question the rationale of including corporate bonds in their strategic asset allocations. They ask why they should invest in assets with limited upward but obviously unlimited downside potential. They question whether credit really offers an adequate return compensation for the embedded risk, and wonder whether an investment in treasury bonds and equities might not be much more efficient than a pure corporate bond investment. Finally, and unsurprisingly, given the credit crisis, they ask themselves whether they shouldn’t avoid credit altogether.

Linking equities with credit In the 1970s, Professor Robert Merton defined the mandatory link between equity and credit markets: based on arbitrage considerations, a corporate bond can be replaced by a default-free bond obligation (eg, treasury) and a short put option related to the firm value – the latter being approximated by the stock price. The different behaviour of treasuries and corporate bonds is therefore driven by the put option, which relates directly to equity performance and its volatility. The fact that a bond-holder is short the put option explains the asymmetric return distribution: ideally the bondholder earns the premium of the short put until its maturity or, in the worst case, loses the whole nominal value. There is no reason why this strategy of implicitly shorting put options in a diversified credit portfolio should be an inferior investment from a riskreturn perspective. Indeed, as the following research will reveal, such ‘synthetic’ credit investments offer an additional source of alpha on top of equities.

How to compare equities with credit Firstly, we want to compare a portfolio of credit (A) with a portfolio of equities and treasuries (B) based on the aforementioned ‘mandatory link’ between equities and corporate bonds. To do this, we can either construct portfolios with equal volatility or with equal returns. The balanced portfolio can be

constructed by determining the daily weights of treasuries and equities that replicate the volatility of a corresponding credit portfolio.

To isolate return differences in asset classes, the treasury and credit portfolios have to be perfectly matched in terms of portfolio duration. Moreover, the comparison must confine itself to the days on which credit volatility can be replicated with a portfolio of equities and treasuries. Finally, the equities and treasuries portfolio can be compared with portfolios with different levels of credit exposure (leverage).

Firstly we construct two portfolios (A) and (B) with equal volatilities and compare their returns. The credit portfolio is approximated by the broad Lehman Euro Aggregate Corporate Index. We obtain a duration-equivalent treasury portfolio by subtracting the credit excess return from the index total return. The stock market is approximated by the Dow Jones Stoxx® 600 Return Index. On each day, we determine the weights of treasury assets and equities

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in our portfolio (B) in such a way that the portfolio volatility precisely matches the volatility of our credit portfolio (A) during the preceding 90 days. We account for non-synchronous trading and exclude days on which we cannot replicate credit volatility with equities and treasuries. We calculate average daily credit excess returns and their volatilities for credit portfolios with leverage factors of between 100 percent and 200 percent.

Secondly, we use the same methodology to construct, on each day, a treasury/equity portfolio that matches the return of our credit portfolio. When allowing for short positions, return matching is always possible. As this methodology is prone to outliers, we analyse median rather than mean volatilities.

Our analysis starts on 1 February, 1999, using the preceding 90-day period to calculate returns and volatilities. The analysis ends on 30 April, 2008 and thus includes the latest credit crisis.

Based on arbitrage considerations, a corporate bond can be replaced by a default-free bond obligation (eg, treasury) and a short put option related to the firm value

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Figure 1: average risk equivalent portfolios credit versus treasury + equities

64%

200% Credit

36%

Treasuries Equities

180% Credit

68%

32%

160% Credit

72%

28%

140% Credit

76%

24%

120% Credit

81%

19%

100% Credit

85%

15%

0%

20%

Figure 1 shows credit portfolios with different levels of leverage on the vertical axis and the composition of the corresponding volatility-equivalent treasury/equity portfolios on the horizontal axis.

Figure 1 illustrates that a 100 percent credit portfolio is, on average, equivalent in terms of risk to a portfolio consisting of 85 percent treasuries and 15 percent equities.

Remarkably, however, in this case we were not able to replicate an equal low-volatility portfolio using treasuries and equities on a considerable number of days. If we gradually increase the credit exposure of our portfolio to 200 percent, the equity share of the volatility-equivalent treasury/equity portfolio increases sharply to 36 percent.

Results for the volatility- and returnequivalent portfolios are shown in figure 2.

It displays the volatility differential (left vertical axis) and the return differential (right vertical axis) between credit portfolios with different levels of leverage (given on the horizontal axis) and matched

40%

60%

treasury/equity portfolios. The graphic indicates that the volatility of the credit portfolios is, on average, lower than that of the return-equivalent treasury/equity portfolio, resulting in a volatility reduction of between 0.7 percent for a 160 percent credit portfolio and a considerable 13.4 percent for a 100 percent credit portfolio. Similarly, the credit portfolios outperformed volatility-equivalent treasury/equity portfolios by 0.04 percent for a 120 percent credit portfolio, and 1.89 percent for a 200 percent credit portfolio.

80%

100%

Eurex options Treasuries and short put options can replicate a credit portfolio and in turbulent markets, such as those experienced during the 2007/2008 credit crisis, it is useful to have such a â&#x20AC;&#x2122;last resortâ&#x20AC;&#x2DC; of liquidity as offered by the options market. Put options are available on a broad range of stocks at the largest European derivatives exchange Eurex and for maturities up to two years, credit protection can be easily bought or sold through equity options.

Treasuries and short put options can replicate a credit portfolio

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Figure 2: advantage of credit portfolios versus treasury + equity

2.0%

16% 14%

1.5%

10% 8%

1.0%

6% 0.5%

4%

Increase of return (%) (Equal risk)

Decrease of risk (%) (Equal return)

12%

2% 0% Decrease of risk Increase of return

100% Credit 13.4% 0.14%

Conclusion In this analysis we compared investment grade credit portfolios with balanced portfolios of treasuries and equities on a daily basis.

The analysis demonstrated, firstly that the risk of a 100 percent credit portfolio can be replicated with 85 percent treasury plus 15 percent equities, on average. The risk of higher equity exposures can only be replicated by leveraging the credit exposure (eg, EUR 200 million in credit have on average the same risk as EUR 64 million in treasuries and EUR 36 million in equities, thus the leverage is 200 percent).

Secondly, that all credit portfolios, on average, outperformed risk-equivalent balanced portfolios of treasuries and equities – even during the period including the latest credit crisis.

Thirdly, that the ex-post return equivalent portfolios of credit had, on average, less risky behaviour than balanced funds with the same returns. Finally, it showed that the

120% Credit 4.4% 0.04%

140% Credit 1.7% 0.42%

160% Credit 0.7% 0.88%

implicit diversified writing of put-options within a credit fund generates an additional premium against the investment alternative in equities and treasuries.

There are two possible explanations for this seemingly ’free lunch’. Either, that the market pricing of put options – and therefore corporate bonds – is based on implicit volatility and because the realised volatility is on average lower than the implied, credit funds reap the return advantage. An alternative explanation is that because credit funds are less liquid, there is an additional premium for that liquidity risk. The same holds for possible differences in tax treatment of the investigated asset classes.

In summary, corporate bond investments will enhance the risk/return behaviour of a strategic asset allocation.

Nevertheless equities should not be ’replaced‘ by credit – instead the smart investor should allocate risk budget to both asset classes in accordance with their alpha requirements.

180% Credit 1.7% 1.38%

200% Credit 5.3% 1.89%

0.0%

Union PanAgora Asset Management Union PanAgora is an independently operated asset management company with two strong partners. The company specialises in pure quantitative strategies for institutional investors. Union PanAgora manages EUR 12 billion in third-party assets, with a total staff of 59 at the end of May 2008.

Helmut Paulus Helmut is a partner and managing director at Union PanAgora, responsible for all strategies in fixed income and asset allocation.

Dr Harald Henke Dr Henke is senior portfolio manager at Union PanAgora. He is researching and implementing credit strategies within the fixed income and asset allocation team.

Contacts helmut.paulus@union-panagora.de harald.henke@union-panagora.de

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Index dispersion and correlation trading SGAM’s Serge Darolles, Eric Talleux and Emmanuelle Jay explain the mechanics behind dispersion and correlation trading and detail how the strategies can be profitably deployed

I

ndex dispersion trading is a very attractive proposition. One can express views and ultimately profit from the relationship between the movement of an index, such as the Dow Jones EURO STOXX 50® Index, and the movements of the index’s components.

Generally, this strategy is classified as volatility arbitrage because the (co-) movements (volatility) of the stocks are arbitraged against the volatility of the index, enabling traders to profit from the difference between the index’s volatility and the weighted average volatility of the components.

Technically speaking, suppose the index return rIndex,t can be written as: 1.

and considering a constant pair-wise correlation then we have: 2.

where N is the number of components in the index, rk,t denotes the return of stock k at time t and wk,t is the weight of stock k in the index at time t.1 From equation 1, the average pair-wise correlation can be computed as follows.

Using:

where Index,t is the index volatility and k,t is the volatility of stock k at time t.

For a well-diversified index we also have the approximation: 3.

The index price is mostly the sum of its components’ prices each multiplied by a fixed quantity (the quantity of each stock in the index). So when computing the returns of the index, it appears that the weight of each stock in the index is time-dependent as in equation 1.

1

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Figure 1: profitability of one-month correlation and dispersion trades on the Dow Jones EURO STOXX 50® Index and its constituents

200%

25%

180%

20%

Implied Correlation Realised Correlation

160%

15% 140%

1M Correlations

10%

120%

5%

100%

80%

0%

60% -5% 40% -10%

Oct 07

Feb 08

Feb 07

Jun 07

Oct 06

Jun 06

Oct 05

Feb 06

Jun 05

Oct 04

Feb 05

Feb 04

Jun 04

Oct 03

Jun 03

Oct 02

Feb 03

Jun 02

Oct 01

Feb 02

Feb 01

Jun 01

Oct 00

Feb 00

Jun 00

Feb 99

0%

Oct 99

20%

Jun 99

Neither volatility nor correlation are constant over time, thus we can never be certain whether we will be more exposed to correlation than to volatility – instead the aim is generally to benefit from the differences between the market implied volatility and the realised volatility.

As shown in figures 1 to 3, implied and realised correlations are far from constant over time, especially on shorter terms over shorter durations. Therefore, the question is whether correlation moves because of changes in volatility, or whether volatility moves because of increases or decreases in correlation? Generally speaking, one can observe that increases in index volatility precede an increase in stock volatilities – this is especially evident in negative scenarios when many investors will use index futures and options to hedge their portfolio.

There are various ways of implementing index dispersion and correlation trades.

Long dispersion: a trader aiming to benefit from index dispersion (long dispersion/short correlation) effectively bets that the components of an index will move more than the index itself and that the components will deliver higher realised volatility than the index. This trade can be implemented either by buying covered options on single stocks and selling covered options on the index, or by buying variance swaps on single stocks and selling variance swaps on the index. Using a variance swap is advantageous operationally, as it does not require daily delta-hedging and position rebalancing. However, variance swaps are generally more expensive to trade than covered options.

Dispersion/correlation strategies were very profitable at the turn of the century.

Since then, however, tightening volatility and improvements in market efficiency have combined to make it more difficult to extract profit from these strategies – indeed, implied volatilities are most frequently higher than realised volatilities, indicating that these strategies are now largely being utilised for risk management and less for opportunistic purposes.

The situation is totally different in Asia

-15%

Figure 1: one-month (implied and realised) correlations and dispersion trades’ profitability, from equations 2, 8 and 9. Realised values (dispersion and correlation) shown at date t are the effective realised values from one month before t until t. Implied values shown at date t are the implied values given one month before by the market.

Figure 2: profitability of six-month correlation and dispersion trades on the Dow Jones EURO STOXX 50® Index and its constituents

Figure 2: six-month (implied and realised) correlations (equation 2) and dispersion trades’ profitability from equations 8 and 9. Realised values (dispersion and correlation) shown at date t are the effective realised values from six months before t until t. Implied values shown at date t are the implied values given six months before by the market.

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Figure 3: profitability of 12-month correlation and dispersion trades on the Dow Jones EURO STOXX 50® Index and its constituents

Figure 3: one-year (implied and realised) correlations (equation 2) and dispersion trades’ profitability from equations 8 and 9. Realised values (dispersion and correlation) shown at date t are the effective realised values from one year before t until t. Implied values shown at date t are the implied values given 12 months before by the market.

where the markets have not yet reached European levels of efficiency and where, as a result, there are still plenty of opportunities to benefit from cheap volatility.

One particularly popular trade in Asia is the ‘Call on Absolute Dispersion’, whose payoff at maturity T is: 4.

where p is the number of stocks in the basket; Si (0) is the close spot price of stock i at start date; Si (T) is the close spot price of stock i at maturity date T; and K is the strike of the option.

This product is ideal if you believe that the stocks in the basket are sufficiently uncorrelated and that, as a result, at maturity T, there will be sufficient realised dispersion around the mean.

One of the major difficulties that

investors face, lies in selecting the subset of an index against which to play the dispersion/correlation of the index.

The subset has to be chosen carefully: it must mimic the performance of the index, but with a lower number of stocks in order to keep transaction costs low and simplify the hedging process. The subset can, of course, be chosen by simply selecting the stocks with the largest index weighting (this will ensure liquidity); but statistics can also be of a great help. For example, the Principal Component Analysis (PCA) is a useful statistical method that can be usefully employed.

Given the returns of the N stockmembers of an index in the past T dates, we can use the PCA to compute T Principal Components (PC), the first q of which will account for a large part of the variance of the data. These q components are a linear

combination of all the index components.

Using the relative contribution of each stock for each of these q components, we are able to identify the most valuable subset of the index to replicate the best overall second-order information contained in the original stocks’ returns.

Other methods such as the genetic algorithm are also very useful to select the q more explicit stocks among the N given any criteria, such that the realised dispersion at maturity will have to be greater than the (known) implied dispersion at the start date, but these algorithms require large computational capacity.

Whatever method used, the strategy requires that one monitors the hedging positions. When derivatives are used, this requires that one hedges the underlying parameters such as the underlying price, the underlying volatility and so on. It is then possible to express the profit and loss (P&L) of a dispersion/correlation strategy as a function of the ‘Greeks’ (sensitivities to parameters).

Using the classical (Black-Scholes) volatility arbitrage, the variation of the P&L of a strategy consisting of a short deltahedged option V on an underlying S can be written as (over each time period t): 5.

where St is the price of underlying S at t, St is the variation of the price of S over the time step t, t is the so-called ‘Gamma’ of the option with , is the supposed-constant implied volatility of the underlying used to price the sold option.2 Considering an index and its N components, the variation of the P&L over a short time period t is then (if we buy N weighted covered options Vi on the components and sell a covered option VIndex on the index):

Equation 5 comes from the Black-Scholes analysis using the relation between the Theta number (time sensitivity of the option) and the Gamma number (second-order spot price sensitivity of the option): 2

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6.

where, as previously noted, the quantities related to the index are subscripted with (Index,t) and those related to each component i are subscripted with (i,t). Observe here, that in equation 5 the weights wi, are now supposed to be constant because they are held constant during the trade and set to their initial values wi,t0 if t0 at trade date.

Neutralising the position in the so-called ‘Dollar-Gamma’ number 2 Index,t = Index,t S Index,t , that is being short Index,t options on the index and being long on each of the N index components we have: 7.

where NIndex,Variance is the variance notional of the index, NIndex,Vega is the vega notional, KIndex is the Index variance swap strike (the price expressed in volatility points), hv2 is the realised variance of the index and/or of each component (computed as the annualised sum of squared log-returns of the underlying) and Ki2 is the Variance Swap strike of component i in the index. As the strike K2 (for the index or the stocks) is given on a variance basis, the variance swap trade is expressed using a notional variance, although volatility managers usually think in vega notional, and use the relation NVega = 2*K*NVariance instead.

Summing all the P&L from trade date t0 to maturity T, the final P&L is then a function of what is called Implied Dispersion (ID): 8.

Here we supposed that

and Realised Dispersion (RD): 9.

with hv2 equal to the sum of squared returns of the stocks or the index from trade date t0 until maturity date.

If variance swaps are used instead of covered options, the P&L of the strategy becomes path-dependent only on realised volatility. By design, a variance swap is a ‘constant-gamma option’ and allows one to play the difference between implied and realised volatility directly. The final P&L of a dispersion trade managed with variance swaps is then: 10.

which implies

wi

SGAM AI / SGAM AI HDG SGAM Alternative Investments is a wholly owned subsidiary of Société Générale Asset Management, dedicated to alternative investments. SGAM AI Hedge Funds Group has created a product range that has been continuously developed and adapted as the hedge fund industry has evolved.

Serge Darolles, head of hedge funds research - SGAM AI Paris Serge joined SGAM AI in 2000 as hedge funds quantitative analyst specialising in equity long/short strategy and funds of hedge funds.

Previously, Serge worked as econometrist at the Caisse Autonome de Refinancement, a consultant within the BNP Paribas Research and Development Department and within the macroeconomic research department of the

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Commissariat à l’Energie Atomique. Serge holds a graduate degree from the École Nationale de la Statistique et de l’Administration, a post-graduate degree in applied mathematics from Toulouse University and a masters degree in applied mathematics from Paris Dauphine. He is an associate teacher at Paris 7 University and a member of the research laboratory in Finance-Assurance of CREST-INSEE. Eric Talleux, senior hedge fund manager – SGAM AI Singapore Eric joined SGAM AI Paris in 2001 as senior hedge funds portfolio manager and later moved to Singapore to launch Asian-focused single hedge funds. Prior to joining SGAM AI, Eric served as head of several trading desks at Banque Paribas. He received an economist and statistician diploma from ENSAE and is a graduate of the École Polytechnique.

Emmanuelle Jay, hedge funds quantitative research – SGAM AI Paris Emmanuelle joined SGAM AI Paris in 2003 as an R&D quantitative finance engineer before moving to the Relative Value Team in 2005. Prior to joining SGAM AI, Emmanuelle worked at the French Aerospace Lab as a PhD student on ‘Radar Detection in nonGaussian Clutter’. Emmanuelle holds a PhD in signal processing and a masters degree in image and signal processing from CergyPontoise University and ENSEA-ETIS Lab. Contacts EMMANUELLE.JAY@sgam.com SERGE.DAROLLES@sgam.com ERIC.TALLEUX@sgam.com

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Equity derivatives in pension funds Poul Thybo, Investment Manager at APK Pensionskasse AG, speaks to editor Natasha de TerĂĄn about the Austrian pension fundâ&#x20AC;&#x2122;s use of derivatives

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P

oul, could you firstly give me a brief description of the fund, its mandate and your role within it?

The fund in question is the APK Pension Fund.

APK is the secondlargest pension fund in Austria with approximately EUR 2.5 billion in assets. I am a senior investment manager with joint responsibility for the investments of the fund. The head of investments has the ultimate responsibility for all investment decisions.

Secondly, could you tell me whether you use derivatives in your funds and, if so, what type of derivatives you employ – over-the-counter (OTC) instruments or exchange traded, and why?

APK currently use exchange traded future contracts, currency forward contracts and we are about to implement a strategy that involves options as well. When the exchange traded derivatives are the most liquid contracts available, we always prefer to use them over and above OTC products – however, this is not always the case. For some strategies, non-standard OTC products can be more useful than standardised exchange traded derivatives, but for us at APK this is the exception rather than the rule.

And what sort of derivatives do you use – just equity, or the full range?

APK currently uses only equity index futures contracts and currency forward contracts, but we will very soon start using equity options as well as fixed income futures.

Focusing on equity index derivatives, could you briefly explain what you use them for, and how regularly you use them?

APK uses equity index futures to manage beta risk and, to a smaller extent, to implement a portable alpha strategy. With respect to beta risk management, derivatives are increasingly replacing cash trans-

actions in our strategies, and we thus use them quite regularly.

Looking back over the past year, could you explain how equity derivatives have (or could have) benefited the performance of your fund and or allowed you to quickly or effectively implement particular investment strategies?

In 2007 it became increasingly obvious to us that the investment picture was at its brightest and stock prices were soon to fall.

We started communicating this to our plan members and explained how we would temporarily reduce the equity exposure with futures in order to preserve performance. The strategy was to use our equity portfolio’s outperformance as a risk budget for the size of the derivatives position. The strategy was highly profitable.

Would you encourage other funds (with due care, knowledge, understanding and risk controls, as well as the appropriately designed approaches) to use equity derivatives?

Yes, of course. Derivatives are not necessarily more complicated than their underlying assets. Improper use of derivatives can obviously do much harm, but so can sitting on one’s hands: derivatives give a flexibility that is hard to achieve in the cash market.

Using exchange traded equity derivatives, what benefits do you find in these products over and above their OTC equivalents?

These days, more than ever, the benefit is that there is direct credit exposure to trading counterparts – the introduction of a central counterparty is a big attraction. In addition, standardised exchange traded products tend to be easier to handle for a relatively small organisation like ours.

Which other derivatives products would you like to see listed on an exchange?

Some markets that are both interesting and important from an investment point of view still lack a well-functioning derivatives market, such as credit default swap index contracts. This increases basis risk for

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About APK APK Pensionskasse is a EUR 2.5 billion multiemployer pension fund. The fund manages assets on behalf of 20 Austrian employers, primarily industrial corporations. Along with equity and fixed income holdings, it has minor investments in private equity, as well as hedge funds and absolute-return strategies.

The pension fund has developed a risk management process to deal with equity market risk (beta). About 50 percent of the fund’s equity portfolio is strategically allocated to Europe, and the fund uses Europe’s most liquid equity index derivatives contract, the Eurex Dow Jones EURO STOXX 50® Index Future.

In 2007, APK performed considerably better than the domestic market average, with a 4.8 percent return. The fund’s equity portfolio performed well thanks to good currency overlay strategies and benchmarks, positive results from tactical asset allocation, manager alpha and hedging measures.

It was after the fund’s equity portfolio had performed better than expected in the first half of the year that APK managers recognised that the investment picture was at its brightest and it was only going to be a short while before stock prices started to fall. The fund conveyed this idea to its plan members, warning that a stock market fall was likely, and telling them it intended to use stock index futures as a protection for the portfolio.

From early June, APK started reducing its equity exposure from 45 percent to between 25 percent and 30 percent of a typical plan’s assets by selling Eurex Dow Jones EURO STOXX 50® Index Futures to reduce the exposure of its equity portfolio’s European portion, and later selling S&P 500 futures to pare its US exposure.

By the time the market correction happened in July and August, the fund was already hedged, and therefore able to maintain its year-to-date equity performance.

For its achievements in using derivatives to hedge both currency and equity risk, APK was crowned winner of the Best Derivatives category in the 2007 IPE Awards. Its strategy was also the subject of an article in the Wall Street Journal Europe.

us, as we have to use proxies for these markets instead. We welcome the day when these markets, too, have a liquid listed derivatives market.

Contact To learn more about APK, visit www.apk.at

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Tailoring solutions with derivatives in a global asset management firm Fortis Investmentsâ&#x20AC;&#x2122; Mark den Hollander and Derick le Roux demonstrate how equity and interest rate derivatives listed on Eurex and ISE can provide useful efficiency gains

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Case study 1: a defined dynamic strategy A defined dynamic strategy introduces a dependency of the portfolio risk level on the funding level of a pension fund. This dependency is introduced in a simple way by defining a different asset allocation at different funding levels. The asset portfolio is split in two parts, a matching portfolio that is ‘riskless’ relative to liabilities, and a return portfolio that is ‘risky’ relative to liabilities.

When implementing a defined dynamic strategy, transaction costs must be kept as low as possible and the existing underlying portfolio must remain as unaltered as possible. This should ensure that the selected active managers can deliver the expected outperformance relative to their respective benchmarks.

Derivative instruments are efficient instruments with which to implement a

Figure 1: funding-level dependent strategic asset allocation (SAA)

% SAA to return portfolio

T

he efficient use of derivative instruments can contribute to better risk-return trade-offs in portfolio management for both private and institutional investors. In these two studies we do not take any explicit directional views, but instead show how derivatives can be used to facilitate the efficient implementation of quantitatively defined strategies.

In the first case study we incorporate derivatives in a defined dynamic strategy that explicitly depends on the funding level of a defined benefit pension fund. The riskreturn profile of the pension fund is enhanced by adjusting the exposure to risky assets as defined by the dynamic strategy using interest rate and equity derivatives.

The second case study shows how a well-diversified portfolio of short equity option positions, added to a portfolio of equities, can generate a more stable performance in comparison with investment funds that do not deploy option strategies of this kind.

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100%

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Funding level SAA to return portfolio SAA to matching portfolio Source: Fortis Investments

defined dynamic strategy. The derivatives portfolio can be viewed as a derivatives overlay, with little impact on the existing physical portfolio.

The dependency of the ‘riskless’ matching portfolio and the ‘risky’ return portfolio is shown in figure 1.

The allocation to the return portfolio presented in figure 1 is the desired exposure at each funding level and also the effective exposure including the derivatives overlay.

The physical allocation to the existing underlying return portfolio is not dependent on the funding level of the pension fund, but rather on the performance of the return

portfolio and the matching portfolio.

The current funding level (FL) as the ratio of current assets (A) over current liabilities (L) can be expressed as FLt=At/Lt. The current assets as the weighted sum of the return portfolio (RP) and the matching portfolio (MP) can be expressed as: At = RPtwRP+MPt(1-wRP) with wRP the weight of the return portfolio. The funding level in the next period is then: FLt+1=At+1/Lt+1 with: At+1 = RPt(1+rRPt)wRP + MPt(1+rMPt) (1-wRP) and Lt+1 = Lt(1+rMPt) with rRP and rMP the return of the return portfolio and matching portfolio respectively.

Derivative instruments are efficient instruments with which to implement a defined dynamic strategy

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For the dynamic strategy to succeed according to the strategy shown in figure 1, we need to adjust the exposures of both the return portfolio and the matching portfolio. To adjust the return portfolio’s exposure (RPtwRP) for a euro-based pension fund we buy (or sell) equity index futures contracts, such as the Eurex Dow Jones EURO STOXX 50® Index Futures (FESX) according to whether the return portfolio’s exposure needs to increase (or decrease). To adjust the matching portfolio’s exposure (MPt(1-wRP)), we buy (or sell) Euro-Bund Futures (FGBL).

Figure 2(A) shows the main results from the forward-looking simulated scenarios for a pension fund with and without the implementation of a defined dynamic strategy using Eurex derivatives. Figure 2(B) shows a more detailed comparison of the two results, focusing on the relative performance at various funding level brackets. It shows that the probability of outperformance of the defined dynamic strategy is markedly better in the lower funding level brackets.

The conclusion from this analysis is that adding derivatives can enhance the riskreturn efficiency for a pension fund, especially in downside risk management. A pension fund benefits from using derivatives, for two principal reasons: firstly, the

The conclusion from this analysis is that adding derivatives can enhance the risk-return efficiency for a pension fund, especially in downside risk management active managers can implement their best views as the existing physical portfolio is unaltered by using derivatives; and secondly, the strategy can be implemented at low cost, while liquidity remains high, facilitating the fund to follow its defined dynamic strategy policy.

Case study 2: a volatility enhanced strategy The volatility enhanced strategy is about exploiting the volatility premium by running a well-diversified portfolio of short equity options. The maturities and sequence of these equity option strategies are kept as

short as possible in order to be able to generate a maximum amount of premium using a minimum notional amount (which limits the worst-case scenario). The principal advantage of this volatility enhanced strategy is that it can be used as an additional source of uncorrelated returns and can be attached to any underlying equity portfolio – making the total portfolio more efficient from a risk-return standpoint.

The option strategies largely consist of writing equity call options on part of an underlying equity portfolio. This strategy generates additional income for which the

Figure 2: forward-looking funding levels with and without a defined dynamic strategy A

Without a defined dynamic strategy

With a defined dynamic strategy

Upper 95% confidence interval Lower 95% confidence interval Median funding level Average funding level Maximum funding level Minimum funding level

186% 132% 161% 162% 231% 110%

187% 135% 158% 162% 251% 124%

B

Funding level bracket

Estimated probability: funding level with dynamic strategy < Funding level without dynamic strategy

Estimated probability: funding level with dynamic strategy = Funding level without dynamic strategy

Estimated probability: funding level with dynamic strategy > Funding level without dynamic strategy

Funding Funding Funding Funding

0% 12% 57% 19%

1% 74% 41% 28%

99% 14% 2% 53%

level level level level

< 130% 130% to 150% 150% to 180% > 180%

Source: Fortis Investments. All numbers are based on a one-year investment horizon

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Figure 3: performance in various market scenarios Market scenario

Movement of equity portfolio including option strategies

Movement of equity portfolio

Strongly rising

~ ~

Rising slightly

~ ~

~ ~

Moving sideways

~ ~

Falling slightly Falling heavily Source: Fortis Investments

investor gives up some of the potential upside in the underlying stocks.

The price of an equity option depends, among other things, on the volatility of the underlying stock. Experience indicates that, in the long term, the discounted volatility is generally higher than justified by the actual volatility of the underlying stock. This difference in volatility can be converted into extra income by systematically writing equity options. To limit price fluctuations in periods when actual volatility is higher than expected, the written equity options can be diversified over a large number of underlying stocks and, in certain instances, it will also be desirable to buy out-of-the-money (OTM) equity options with the same maturity as the short equity options positions if they are trading at the same implied volatility level on which at-the-money (ATM) equity options are being sold. For example, the purchase of OTM equity call options from time to time will provide protection against tail event risk.

Given the put-call parity for Europeanstyle options (and ignoring dividends), a portfolio consisting of 100 stocks and short 50 equity call options is the same as a portfolio of 75 stocks, short 25 equity put options, short 25 equity call options (or jointly together short 25 straddles) and 25 in cash.1 For example, consider a portfolio that consists of a 75 percent investment in a well-diversified equity portfolio and 25 percent in option strategies – short straddles and cash – as described above.

Figure 3 shows how the performance of

such a portfolio behaves relative to a 100 percent investment in a well-diversified equity portfolio under different market circumstances. The performance becomes less volatile, meaning that such an investment will not benefit to the full extent from price gains in rising markets, but that losses will also be limited in falling or weak markets.

An investment in such a portfolio offers relatively stable returns. This is made possible by the active use of equity option strategies. The effect is evident from figure 4, which shows a simulation of historical

This difference in volatility can be converted into extra income by systematically writing equity options

In simple terms the put-call parity relationship can be represented by: call option + cash = put option + stock or by call option = put option + stock - cash.

Given the put-call parity, a portfolio of 100 stocks and short 50 call options is equivalent to a portfolio of 75 stocks, short 25 straddles and 25 in cash.

The formula becomes: 100 stocks – 50 call options = 100 stocks – 25 call options – 25 call options = 100 stocks – 25 call option – 25 (put options + stocks – cash) = 100 stocks – 25 call options – 25 put options – 25 stocks + 25 cash = 75 stocks – 25 call options – 25 put options + 25 cash = 75 stocks – 25 straddles + 25 cash.

1

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data. This back-test indicates that the use of equity option strategies results on average in lower peaks and less market bottoms in comparison with an equity-only investment portfolio.

Figure 4 clearly shows the reduced performance volatility in the equity option strategies: full advantage is not taken of all price gains in sharply rising markets, but a significant improvement in performance can be obtained in falling or sidewaysmoving markets.

Important information The views and opinions expressed above may be subject to change at any given time.

Individuals are advised to seek professional guidance prior to making any investments.

Fortis Investments Fortis Investments is the autonomous global asset management arm of the Fortis group.

Fortis Investments is a top-tier asset management company with a global footprint – more than 40 investment centres, 600 investment professionals worldwide; more than 2,000 employees in more than 30 countries and EUR 245 billion in assets under management (as per 1 April, 2008).

The investments division has one prime objective: creating alpha. The division is made up of more than 40 autonomous, fully-accountable investment centres, each responsible for the management of a single asset class. Fortis maintains small decisionmaking teams to avoid a ‘consensus’ culture, which it believes leads to performance around the benchmark. Instead, its aim is always to beat the market.

Mark den Hollander Mark is chief investment officer of the structured solutions investment centre, which has EUR 34 billion in assets under management (as per 1 April, 2008). He has 17 years of investment experience and has been involved in managing structured investment solutions since 1997. He is specialised in structured products, liability driven investment, fiduciary management, volatility and structured beta products, and lifecycle investing, all of which use derivatives strategies. Mark holds a Master’s degree in operations research and

Figure 4: back-tested equity portfolio showing options strategies versus an equity portfolio 30,0 25,0

Equity portfolio including option strategies

Equity portfolio

20,0 15,0 Return %

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10,0 5,0 0,0 -5,0 -10,0 -15,0 1999

2000

2001

2002

2003 Year

2004

2005

2006

2007

Source: Fortis Investments

econometrics from the Erasmus University, Rotterdam.

Derick le Roux Derick is head of research within the structured solutions investment centre and is responsible for managing the research function. He applies recent academic thinking and industry developments to provide innovative and pragmatic solutions for clients. He has 13 years of investment experience, having

started in investment banking and been managing portfolios – both passive and active mandates – using derivatives since 1998.

Derick holds a Master’s degree in finance from the University of London and the PRM designation from the Professional Risk Managers International Association (PRMIA).

Contacts mark.denhollander@fortisinvestments.com derick.leroux@fortisinvestments.com

An investment in such a portfolio offers relatively stable returns.This is made possible by the active use of equity option strategies

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Delivering absolute returns Raimund Saxinger of Frankfurt-Trust Asset Management explores the absolute return vogue, dispelling some of the myths behind it and outlining how Eurexâ&#x20AC;&#x2122;s equity and equity index futures and options contracts can be used to deliver absolute returns

M

any factors have contributed to the growing demand for absolute return strategies.

The big swings in equity markets and the associated peakto-trough losses and defaults at the beginning of the decade have triggered accounting changes and forced huge asset gatherers, such as pension funds and insurance companies, to take a fresh look at their strategies and investments.

Advances in computing power have meanwhile given investors a clearer picture of their liabilities and the risks and opportunities created by their maturity structures.

Another often forgotten, but very powerful influence on the development of the absolute return investment vogue, is the promise made by pension funds and insurers. They have always promised their customers nominal returns, not real ones.

In an environment of high nominal returns, any shortfalls in investment returns are made

up, in absolute terms, by the inflation content; inflation effectively bailed out those with mediocre investment strategies and insufficient real returns. However, in low return environments averagely performing strategies are not guaranteed to yield positive returns â&#x20AC;&#x201C; hence the need for a new breed of investment strategies.

Advances in computing power have given investors a clearer picture of their liabilities

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The purpose of this article is to provide an overview of what an absolute return strategy is and help the investor make informed decisions on which strategies he or she should choose.

Firstly a word of caution: the track records of some absolute return strategies have been patchy at best in recent years.

Furthermore, not all strategies marketed as absolute return really aim to deliver absolute returns. Some do not even go under the label of ‘absolute return’, instead using the ‘total return’ moniker.

Bearing in mind that total return is defined as ordinary income plus capital gains/losses and is as likely to be positive as it is negative, ‘total return’ is as useful a description as ‘profitable investing’.

In addition, there are ‘strategies’ that are marketed as absolute, that are in fact long-only strategies that have simply had good runs. Real-estate is the best example of that: Remember the mantra ‘real-estate always goes up’? This is momentum investing dressed up as absolute return.

Real absolute returns In general terms, absolute return strategies are strategies that deliver positive returns, independent of general market movements. One popular way of trying to achieve this is by combining different asset classes that are believed to be lowly correlated (the expectation being that negative returns in one asset will always be compensated by positive returns in another one).

The problem with this strategy is that it has led to increasingly adventurous definitions of what an asset class is. More importantly, no sooner is an ‘asset class’ discovered, than the innovators’ premia are arbitraged away, as the wider market quickly adopts similar strategies, driving correlations up and eroding the diversification benefit.

Bearing in mind that what investors really want – limited downside with unlimited upside, ie, an option-like payout profile – we can quickly conclude that the only way of achieving such profiles is by using derivatives. There are, admittedly, some well-known strategies that employ cash instruments to deliver option-like profiles. However, these strategies all

Absolute return strategies are strategies that deliver positive returns, independent of general market movements suffer from the fact that they are pathdependent; they fail when they are needed most, as the 1987 crash demonstrated very clearly.

In recent years, Eurex has added an impressive array of instruments that can be helpful – if not vital – when implementing such strategies. They are helpful because they introduce two necessary features: non-linearity and (true) negative correlation. Basically, all absolute return strategies can be traced back to these two features.

We will now take a closer look at these two features and the opportunities and challenges they offer.

constitute an expense, but it also varies over time. Be it a protective put or zero bond plus call, both equal each other (the so-called put-call-parity) and become less viable with rising volatility.

Therefore, the strategy deployed has to reduce costs. This can either be achieved by limiting the upside, a strategy known as a costless collar, or by combining options on different instruments, using both nonperfect correlation and different costs of options as reflected in implied volatilities.

A costless collar requires that one buys an index put to protect an existing equity portfolio, and finance this put by selling an index call at a higher strike price. A typical payoff-profile for this strategy can be seen in figure 1.

For a portfolio of German equities, this can be done by using Eurex options on DAX®, for a portfolio of Eurozone equities by using Eurex Options on the Dow Jones EURO STOXX 50® Index. In choosing the strike prices and evaluating the corresponding option premia, one has to bear

Non-linearity Non-linearity is useful as it offers the required optionality in payout structures.

It can be found in the options Eurex lists on single stocks and indexes, but unfortunately convexity, or being long gamma, comes at a price: the price being the option premium paid. Not only does this

Figure 1: a typical payoff profile on a costless collar

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Strategy

Opportunity

Risks

CPPI Protective put Costless collar Long-short inter-market Long-short intra-market

Potentially unlimited upside Potentially unlimited upside Minimises vola risk, costs known in advance Potentially huge moves in one direction Better diversified and better predictability than inter-market

Path-dependent Costs, especially in a high-vola environment Requires (limited) positive market movement Successful macro forecasting required Depends on smaller moves, potentially an overcrowded trade

in mind that the blue chip index DAX® includes dividends whereas the Dow Jones EURO STOXX 50® Index does not.

This strategy eliminates the downside risk, but it depends on a positive market movement (albeit a limited one), to yield a positive return. Without this, the return will be close to zero. Thus the very careful selection of strike levels and maturities and timing are necessary to add further value to the strategy.

A variation of this strategy is to use options on different instruments for the protective put and the financing call.

Instead of selling index calls, calls on individual stocks (or on a different index) can be sold, taking advantage of the higher implied volatility and therefore higher option premia of single stock options. This adds another potential source of performance, and means that the strategy does not rely entirely on a positive market return, but it also introduces another source of risk.

This strategy can be executed easily on exchange, since Eurex offers options on all DAX® and Dow Jones EURO STOXX 50® Index constituents. However, the risk in this strategy, which is also known as dispersion trading, lies in the underlying assumption that the correlation between the individual stocks and the index will not be lower than the correlation implied by the options market – in other words the strategy hinges on there not being a change in the dispersion of the different underlyings.

Negative correlation True negative correlation is based on the ability to short. Even though there can be negative correlation without shorting conceptually, a true and sustainable negative

correlation requires the ability to short.

For example, one might reasonably assume that there should be a negative correlation between oil companies and airline stocks, since as the price of oil rises, oil stocks will benefit and airline stocks suffer.

However, both sectors are also correlated to general market risk, and in the case of a recession the demand for both sector’s products will suffer severely. Consequently, what is needed instead is not instruments with a low correlation, for this correlation tends to go up at the most inconvenient time possible, but rather instruments that are highly correlated and that can be used as a long-short-combination to partially offset each other. This can be done either by combining entire markets or single stocks, however, unless this is a pure arbitrage strategy, which is rarely the case, forecasting risk is always involved.

As the world of absolute return evolves and styles and strategies become more clearly defined, investors will be welladvised to look at and combine a multitude of different absolute return strategies rather than relying on a single strategy. In (long-only) equity investing there are value and growth strategies, among others, and since one might work in certain market conditions, and another in slightly different ones, the prudent investor would combine a good value strategy with a good growth strategy. This way the investor would have the comfort of knowing that while both will have their strong and their weak moments during any given cycle, combined they should both beat the market.

In short, just as there are many long only equity investment strategies, but none that are guaranteed to deliver returns in all market conditions; fur-

thermore, there are many absolute return strategies – and all should be considered.

Frankfurt-Trust Asset Management Founded in 1969, Frankfurt-Trust is a German asset management company with more than EUR 18 billion assets under management. It is owned by Europe's largest privately-owned banking group and caters for both retail and institutional investors. Frankfurt-Trust invests across all major asset classes, offering an individual and personalised service and prides itself in being able to enter and exit markets efficiently. It is an active manager covering all major markets as well as niche products, and offers attractive riskreturn-profiles.

Raimund Saxinger Raimund is a senior fund manager at Frankfurt-Trust, where he is responsible for strategic asset allocation as well as absolute return strategies. He has 17 years’ experience managing equity as well as balanced mandates for institutional investors and developing quantitative allocation strategies. Prior to joining Frankfurt-Trust in 2000, Raimund had been responsible for developing the equity division of Postbank Invest. He previously worked for allfonds investment, now the German Unit of Pioneer. He holds a Master's degree in business administration from the University of Passau and is a licensed Eurex Trader.

Contact Raimund Saxinger Tel: + 49 69 9 20 50 150 raimund.saxinger@frankfurt-trust.de

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Exploiting dividends with the Dow Jones STOXX®; on estimations, such as the FTSE Index; or on free float market capitalisation, in the case of Deutsche Börse’s DivDax®.

Following the growth of trading volumes and assets under management in dividendbased ETFs, Eurex launched futures and options contracts on two of the most widely followed European dividend indexes, the Dow Jones EURO STOXX® Select Dividend 30 Index and the Deutsche Börse’s DivDAX®.

Both the Dow Jones EURO STOXX® Select Dividend 30 Index and the DivDAX® have outperformed their blue chip benchmarks over the last eight years with an even lower volatility – an appealing peculiarity, particularly for indexes with fewer components than their broader benchmarks.

The two dividend indexes in question have a much higher sharpe ratio (0.59 Dow Jones EURO STOXX® Select Dividend 30 Index vs 0.10 Dow Jones EURO STOXX 50® Index and 0.30 DivDAX® vs 0.07 DAX®) and, by construction, a much higher dividend yield.

The contract size of Eurex’s DivDAX® Futures is around six times smaller than DAX® Futures. The Dow Jones EURO STOXX® Select Dividend 30 Index Futures are around one third smaller than Dow Jones EURO STOXX 50® Index Futures.

When the internet bubble burst at the turn of the century, observers rushed to comment on the ‘death of the dividend’, but the total returns of dividend-paying stocks have since substantially outperformed those of non-dividend-paying stocks. Paolo Giulianini examines how dividend derivatives can be used to exploit this phenomenon

I

nvestors have begun seeking ways of exploiting this phenomenon, and major index providers have looked to develop new kinds of equity indexes. The aim has been to find ‘better’ indexes than the traditional market capitalisation-weighted indexes that perform better either in terms of return, risk, sharpe ratio or correlation.

The Dow Jones US Select Dividend Index was launched in November 2003 and the Dow Jones STOXX® Select Dividend Index in 2005. Both have met with extraordinary demand from institutional and retail investors seeking a consistent dividend index.

Other index providers have since launched dividend instruments and there are now 11 dividend indexes. However, only a handful of them have listed futures.

All 11 dividend indexes have impressively outperformed the key blue chip indexes. As indicated in graphic 1, a comparison between the Dow Jones EURO STOXX® Select Dividend 30 Index, and the most relevant blue chip index, the Dow Jones EURO STOXX 50® Index, shows that the dividend benchmark has yielded impressive results.

In May 2005 Deutsche Börse listed the first exchange traded fund (ETF) written on a dividend index. This allowed investors to use dividend indexes as an investment tool for the first time – rather than solely as a benchmark or as an analytical instrument.

Since launch, assets under management in dividend-based ETFs and structured products have grown significantly.

Today, almost 600 financial products are based on Dow Jones STOXX® Select

Dividend Indexes and 600 products are based on the Deutsche Börse Select Dividend Index. More than 30 different investment banks have issued products linked to dividend indexes.

Activity has taken off in the European retail segment, while institutional interest, shown in the dividend-based ETF market, is growing incrementally. As a result, more than EUR 7 billion assets under management are now linked to dividend indexes with a monthly turnover in excess of EUR 300 million. Furthermore, two dividend-based ETFs already rank among the top 15 ETFs in terms of assets under management.

In Europe today, long-only investors can access eight different dividend indexes through ETFs. The funds are issued by four different managers and are listed on eight different European stock exchanges.

On these eight dividend indexes, selections and weightings are based on net dividend yield. Variously, the yields are calculated on a historical basis, as is the case

Graphic 1: Dow Jones EURO STOXX® Select Dividend 30 Index vs. Dow Jones EURO STOXX 50® Index 4000

SD3T Index

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SX5T Index

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500

0 Mar 00

Mar 01

Source: UNICREDIT, Eurex

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Mar 03

Mar 04

Mar 05

Mar 06

Mar 07

Mar 08

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Graphic 2: European dividend-based ETF trading volumes (in millions of euros) 800

with a profit of about 78,000 EUR (+EUR 44,000 on FEDV and +EUR 34,000 on FESX).

Sum of Ums Indexprovider STOXX® FTSE Dt. Börse Dow Jones

700 600 500 400 300 200 100 0

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6 2007

Hence, these two futures are particularly interesting to retail investors and hedgers of retail structures, offering investment bank providers of dividend-based structured products a perfect, clean and easy means of hedging out their dividend risk.

In the first quarter of 2008, some of the providers’ profitability fell markedly as a result of their being structurally long dividend risk and dividends falling, demonstrating that dividend risk cannot be ignored.

The launch of Eurex’s new dividend futures contracts marked a major turning point in dividend trading. By definition, a futures contract provides investors with the most efficient and low cost access to any market segment.

The dividend index futures have expanded dividend trading opportunities, giving very precise exposure to this profitable market segment. The futures contracts have innumerable benefits – they afford leverage and increase transparency, they allow investors to short less liquid stocks without needing to borrow each component and they make it easier to trade dividends against another asset class. In addition, there is guaranteed liquidity in the contracts via established market makers; the introduction of a central counterparty reduces credit risk; the contracts involve no management fees and incur no tracking error against the underlying index; they are simple and easy to use hedging instruments for structured products; and they offer arbitrage and dividend enhancement possibilities.

Trading strategy 1 In this trade our aim is to exploit the under-

8

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1 2008

performance of the select dividend index against the Dow Jones EURO STOXX 50® Index during and after the dividend season (mid-March to the end of June), without increasing our overall exposure to the Eurozone equity segment (April to June).

Using the futures, we can short the ‘less liquid’ stocks instantaneously without needing to borrow each individually through an open repo.

We go short the Dow Jones EURO STOXX® Select Dividend 30 Index Futures (FEDV) and go long the Dow Jones EURO STOXX 50® Index Futures (FESX).

We invest the same amount of money (EUR 1 million) in going long 30 FESX Futures (June expiry) and going short 40 FEDV Futures (June expiry). On 17 March, 2008, one FESX Future was worth EUR 33,700 while one FEDV Future was worth EUR 25,500 (with a ratio of 1.0 FESX Futures to 1.3 FEDV Futures).

On 17 March at 5.00 pm, the FEDV price was EUR 2555 bid, EUR 2558 offered and the FESX was EUR 3371 bid, EUR 3372 offered. We sell 40 FEDV futures at EUR 2555, and buy 30 FESX futures at EUR 3372. At expiry on 18 June the FEDV Futures settled at EUR 2445.07 and the FESX Futures at EUR 3484.63. We thus buy back the 40 FEDV Futures we had sold in March at EUR 2445.07 and sell back the 30 FESX Futures we had bought in March at EUR 3484.63.

During the period 17 March, 2008–18 June, 2008, the FESX rose 3.34 percent and the FEDV, being affected by the downturn of high dividend-paying stocks, fell 4.30 percent. Thus, in this example, we ended

Trading strategy 2 This strategy seeks to exploit the beneficial withholding tax treatment of ETF issuers and futures contracts – total return indexes reinvest 100 percent, less the applicable withholding tax. These effects mean that listed products on dividend indexes give investors a better chance of beating the indexes than replicating the indexes directly through cash investments.

The table below shows the witholding tax treatment that is applied to the dividends paid on stocks held by European domiciled funds (the net amount earned on dividends usually ranges between 70 and 85 percent of the gross nominal paid). Futures market makers and ETF issuers are able to partially offset this tax effect through stock lending and equity financing operations.

These beneficial effects are particularly notable because dividend indexes are not based on ‘growth stocks’ but on stocks with large annual dividend yields, which would be most impacted by the withholding tax treatment.

Country WTH in % Country WTH in % Australia 30.00 Latvia 10.00 Austria 25.00 Lithuania 15.00 Belgium 25.00 Luxembourg 15.00 Bulgaria 15.00 Malta 35.00 Canada 25.00 Netherlands 15.00 Cyprus 0.00 New Zealand 30.00 Czech Republic 15.00 Norway 25.00 Denmark 28.00 Poland 19.00 Estonia 22.00 Portugal 20.00 Finland 28.00 Romania 16.00 France 25.00 Singapore 0.00 Germany 21.10 Slovak Republic 0.00 Greece 0.00 Slovenia 20.00 Hong Kong 0.00 Spain 18.00 Hungary 10.00 Sweden 30.00 Iceland 15.00 Switzerland 35.00 Ireland 20.00 United Italy 20.00 Kingdom 0.00 Japan 20.00 USA 30.00

Trading strategy 3 Because the four main European dividend indexes have similar compositions, there is a range of opportunities for exploiting arbitrage between them through futures con-

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Chart 3: the ‘overlapping’ composition of the four major European dividend indexes 9 stocks in common FUDP/SD3P Brit Insurance Holdings Plc United Utilities Plc Lloyds TSB Group Plc Tomkins Plc DSG International Plc Alliance & Leicester Plc Cattles Plc Trinity Mirror Plc Provident Financial Plc

FTSE UK Div

DJ STOXX® Select Dividend

3.02%

5.07%

2.90% 2.83% 2.56% 2.25% 2.24% 1.89% 1.87% 1.36% 20.92%

5.19% 4.11% 5.57% 7.80% 4.01% 3.59% 3.05% 4.87% 43.25%

11 stocks in common SD3P/SD3E FORTIS Belgacom SA Irish Life & Permanent Plc Deutsche Telekom AG-registered RWE AG-NON VTG PFD Deutsche Bank AG-registered Credit Agricole SA Bank of Ireland France Telecom SA Allied Irish Banks Plc Wienerberger AG

4.01% 3.26% 3.22% 3.04% 2.86% 2.75% 2.71% 2.65% 2.59% 2.44% 1.97% 31.49% 74.73%

tracts. Futures contracts offer valuable saving costs compared to the costs that would normally arise from trading the indexes’ individual components.

The success of dividends as an asset class was thrown into relief by the strong performance of the dividend indexes and the resulting growth in the assets under management of ETFs linked to European dividend indexes. More recently, the two Eurex dividend futures contracts have introduced further investment and trading opportunities, which can be exploited by structured product desks, ETF market makers and delta-1 desks. The growth in liquidity that will likely be stimulated by these users

DJ EURO STOXX® DivDAX® Select Dividend 30 Index

4.95% 4.03% 3.98% 3.72% 3.51% 3.40% 3.34% 3.28% 3.22% 3.02% 2.44% 38.89% 11 stocks in common SD3E/DivDAX® Deutsche Telekom AG-registered Muenchener Rueckver AG-registered BASF SE Allianz SE-registered Deutsche Bank AG-registered Thyssenkrupp AG Deutsche Post AG-registered E.ON AG

should help grow the appeal of the dividend asset class even further.

UniCredit Group – Markets and investment banking UniCredit Group ranks among the top three banks in the Eurozone and is present in 23 countries. It has more than 40 million clients, 10,000 branches and approximately 180,000 employees (as of June 2008). The markets and investment banking (MIB) division incorporates the group’s financial markets and investment banking activities.

The MIB division operates an international platform with about 4,158 professionals in almost 40 countries.

3.72% 3.50% 3.40% 3.40% 3.40% 2.86% 2.57% 2.36% 25.21%

8.69% 8.47%

17.16% 8.69% 7.62% 10.89% 10.47% 8.47% 4.50% 4.63% 10.71% 65.99%

Paolo Giulianini Paolo is director, head of ETF trading and advisory within markets and investment banking at UniCredit Group. He runs the ETF team based in London, Munich and Milan, covering all issuers, all asset classes and all exchanges in the ETF market. Paolo spent 14 years as head of delta-1 products at Banca IMI, where he was responsible for making IMI into one of the leading market makers for ETFs in Germany, France and Italy. He holds a BA degree in financial markets from Bocconi University in Milan.

Contact Paolo.Giulianini@unicreditgroup.co.uk

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139

Investing in Russia with equity derivatives Troika Dialog’s Douglass Welch looks at the drivers behind the strong outlook for Russia and explains how investors can use Eurex’s equity derivatives products to gain exposure to this fast-growing market

T

he Russian financial markets have been expanding at great speed over the last four years. The country has shaken off its legacy of debt, built current account surpluses and is now considered investment grade – as evidenced by Moody’s recent upgrade of Russia’s sovereign debt rating to Baa1 with a positive outlook.

Troika Dialog estimates that Russia will overtake the UK in 2008, to become the sixth largest economy in the world (in purchasing power parity terms), and the second largest in Europe. In nominal terms, the International Monetary Fund (IMF) currently ranks Russia in eighth position.

It is a measure of the tumultuous impact of the political and economic changes of the mid-1990s that it was not until the end of 2007 that Russian GDP finally exceeded the real GDP level recorded in 1990. But there now appears to be a common agreement that Russia has further to rise: Russia has an industrial base similar to Central Europe and

petrochemical resources on par with some Middle Eastern countries.

One crucial difference between Russia and its peer group is its population size – some 80 percent greater than its nearest Central and Eastern Europe, Middle East and Africa [CEEMEA] comparator.

The European Bank for Reconstruction

Russia has petrochemical resources on par with some Middle Eastern countries

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and Development (EBRD) estimates that the Russian middle class now accounts for approximately 18 percent of its total population and average monthly wages have been growing at more than 12 percent annually since 1999. The net effect of this can already be seen across the economy.

For example, Troika research estimates that Russia has twice as many mobile phone subscribers as any other European country.

Automobile sales should approach four million units in 2008 – not far below the projections for that of the German market.

As the effects of economic growth reverberate though the various market sectors, the Russian economy is becoming increasingly responsive to the demands of its domestic consumers. The sheer size of its population and resource base on which it can now build its economy should allow Russia to accelerate beyond its CEEMEA peers.

The ratio of capital investment to GDP has been low relative to global and CEEMEA averages. But low investment levels have been interpreted as implying structurally high(er) rates of return on capital invested.

This thesis has encouraged increasing capital inflows and corporate Russia has responded. Russia’s market capitalisation now exceeds USD 1.1 trillion, more than five times the size of the Turkish market.

The performance of the Russian com-

ponent, relative to China or India within the MSCI BRIC Index, is evidence that Russian growth may well weather the economic storms unleashed by the US credit crisis.

The ambitions of numerous corporates, such as Gazprom’s publicly stated desire to become the largest corporation in the world, further amplify commercial development potential. This corresponds with trends in asset management suggesting managers are moving away from China towards Brazil, Russia or South-East Asia.

Troika Dialog estimates that Russia is one of the cheapest global emerging markets (GEMs) because it trades at 11-times 2008 and 9.5-times 2009 estimated earnings.

Several pools of capital have been engaged in the rapid economic expansion, leading corporate Russia to seek equity listings in Frankfurt, London, Moscow, New York, Vienna and Hong Kong. That Russian equities are found spread across several Western exchanges may also reflect the geographical spread of Russia, which occupies one-ninth of the global land mass.

However, the spread of Russian-listed equities presents challenges to investors, particularly as investment flows increase.

Recent moves by the Russian government to restrict the free-floats of new depository receipts will be the first of many moves, in our opinion, towards a centralisation of liq-

uidity. This is a step welcomed by most participants. The government has also stated that it wishes to have completed building an international financial centre in Moscow by 2020 – a target that reflects the potential within Russia, but that also addresses the challenges that still lie ahead.

New tools Having recognised Russia’s economic potential, the investment community is naturally interested in gaining exposure to the market and seeking out appropriate risk management tools. One such ‘tool’ has recently been made available – the futures and options contracts on the MSCI Russia Index launched by Eurex.

The USD-based MSCI Russia Index, which is designed and managed by MSCI Barra, comprises the 28 largest Russian companies by market capitalisation that meet the necessary liquidity and free float requirements, whether they are listed in Russia, London or New York.

The index is reviewed on a quarterly basis, which should allow it to incorporate major new IPOs and corporate actions quickly. It should also be more representative of the domestic market flows than rival indexes, because it follows the Russian market trading calendar.

Troika Dialog believes the new MSCI

Figure 1: MSCI Russia Index performance charted against the MSCI Emerging Market and Emerging Europe Indexes 700 600

MSCI Emerging Markets MSCI Emerging Europe MSCI Russia

400 300 200

02/07/2008

02/03/2008

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Russia Derivatives contacts should prove to be key trading products for all potential investors. The introduction of these contracts is in line with the government policy of further centralisation since the Medvedev regime wants to both increase investment flows into the Russian market and to encourage the development of modern investment practices and hedging tools.

In addition to the MSCI Russia Futures contracts, Eurex also offers 18 single stock futures and five equity options on Russian stocks. The exchange’s roster of single name equity derivatives will most likely expand as demand and liquidity in the underlying dictates.

Eurex’s Wholesale OTC Trading facilities will prove particularly attractive to institutional investors, and are useable across the exchange’s full suite of Russian underlyings. The minimum trade size required for the Wholesale Trading facility is 100 contracts for MSCI Russia Index Futures and Options; 250 contracts for equity options contracts and just one contract for single stock futures.

Another attractive feature within Eurex’s Wholesale OTC Trading facility is the Flexible contract tool, which allow investors to customise their futures and options contract terms – ie, specifiying particular maturities and strike prices. This should prove particularly attractive for investors hedging with the MSCI Russia Index.

Prior to the Eurex MSCI Russia Index futures and options contract launch, investors could hedge in London, Vienna or Moscow, but the tools available were somewhat imperfect. Troika Dialog estimates that in the first quarter of 2008, the weekly average traded volume of listed Russian Single Stock and Index Derivatives across all available exchanges exceeded USD 2.60 billion. In addition, a further USD 8-10 billion will have been traded in the OTC derivatives market, largely offshore.

The London Stock Exchange-sponsored Russian IOB Index and the Wiener Boerse’s RDX Index were the primary indexes available to Western investors. However, neither index was widely referenced by institutional investors – nor were the indexes broad enough to provide an accurate proxy for commonly held portfolios.

141

As the effects of economic growth reverberate though the various market sectors, the Russian economy is becoming increasingly responsive to the demands of its domestic consumers

The domestic RTS Index is meanwhile still in its infancy. International investors and their custodians are waiting for clear signs from the government that legislative practices will evolve to support greater legal certainty and consistent enforcement.

Troika Dialog believes that international investor usage of listed Russian derivative contracts is set for exponential growth and welcomes Eurex’s new MSCI Russia futures and options contracts. They should help drive the consolidation desired by both market participants and the Russian government. Investors attracted by the economic fundamentals presented by the large Russian consumer market and its strength relative to its regional and global emerging market peers naturally require such tools for hedging and investment purposes. As their activity increases, liquidity in the contracts should gather pace.

Troika Dialog Founded in 1991, Troika Dialog Group is the leading independent full service investment bank and asset management firm in Russia and enjoys the highest counterparty credit rating of all Russian investment banks. The Group’s business consists of securities sales and trading, investment banking, private wealth and asset management, retail distri-

bution and private equity. Troika Dialog has operations in 22 cities across Russia, as well as offices in London, New York, Kyiv, Almaty and Nicosia. Troika Dialog has the leading market share in Russia in domestic and international equity and local currency fixed income securities trading; in mergers and acquisitions advisory services; and in the management of open ended and interval mutual funds. Troika Dialog Group had total assets of USD 8.17 billion and total capital and reserves of USD 645 million as of 31 March, 2008 under USGAAP interim unaudited financial statements. Total assets under management as of 31 March, 2008 exceeded USD 10 billion.

Douglass Welch Douglass is the head of derivatives sales at Troika Dialog. Prior to joining Troika, Welch worked with Citigroup for 14 years, where he was responsible for the bank’s Institutional Derivative Sales Teams in Germany and Central Eastern Europe, Middle East and Africa (CEEMEA). He began his career in interest-rate derivatives in 1985, before gradually switching into equity derivatives. He then worked with emerging market derivatives at Salomon Brothers.

Contact douglass_welch@troika.ru

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Advertiser index

Index of advertisers Accenture

. . . . . . . . . . . . . . . . . . . . . . . . .22

BBVA . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .9

AFS Brokers . . . . . . . . . . . . . . . . . . . . . . . .90

icubic . . . . . . . . . . . . . . . . . . . . . . . . . . . . .73

Alpha Executive Search . . . . . . . . . . . . . . .6

Meyer Lustenberger . . . . . . . . . . . . . . . . .18

Banca Akros . . . . . . . . . . . . . . . . . . . . . . . .57

OTCex Group . . . . . . . . . . . . . . . . . . . . . . .17

Bank Vontobel . . . . . . . . . . . . . . . . . . . . . .29

Pali Capital . . . . . . . . . . . . . . . . . . . . . . . . . 2

Bloomberg Tradebook . . . . . . . . . . . . . . .35

Rabobank . . . . . . . . . . . . . . . . . . . . . . . . .144

Cantor Fitzgerald . . . . . . . . . . . . . . . . . . . .4

Renaissance Capital . . . . . . . . . . . . . . . . .37

Donaldson Legal Consulting . . . . . . . . . .48

RJF Global Search . . . . . . . . . . . . . . . . . .143

Dresdner Kleinwort . . . . . . . . . . . . . . . . . .12

Shirebrook Commodities . . . . . . . . . . . . .63

DTCC . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .14

SWX . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .94

EMC2 Document Sciences . . . . . . . .32, 54

Tradition . . . . . . . . . . . . . . . . . . . . . . . . . . .78

Fidessa (LatentZero) . . . . . . . . . . . . . . . . .45

The City Secret . . . . . . . . . . . . . . . . . . . . .51

Fixnetix . . . . . . . . . . . . . . . . . . . . . . . . . . . .68

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If you can trade it, we can broke it

Fed up with your current broker service?

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