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Equity Derivatives Yield Enhancement and Hedging Strategies August 2003

Equity Derivatives Yield Enhancement and Hedging Strategies August 2003. Industry Trends. Low return environment over the last 3 years Asset Managers seeking for tighter controls on cost, risk and increased performance Generate Alpha over and above a specific benchmark

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Equity Derivatives Yield Enhancement and Hedging Strategies August 2003

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  1. Equity DerivativesYield Enhancement and Hedging StrategiesAugust 2003

  2. Industry Trends • Low return environment over the last 3 years • Asset Managers seeking for tighter controls on cost, risk and increased performance • Generate Alpha over and above a specific benchmark • Asset Allocation Implementation • Yield and Return enhancement strategies • Derivatives and related instruments represent the toolset that is used to implement asset allocation and enhance portfolios returns • Usage of these products has increased significantly and have given a clear edge to their users versus their competition or the benchmark they are measured against.

  3. Who are using these Products? • Index Funds • Passive Funds • Active Stock Pickers • Aim to Maximize Absolute Returns • Aim to Generate Maximum Alpha over their Benchmarks

  4. Yield & Return Enhancement Non Options Options Securities Lending Securitised Products Swaps Single Stock Futures Options Writing Type of Investor Long Only/ No Derivatives Long only/ Some Derivatives Hedge Funds Most likely to use Likely to use Unlikely to use

  5. Yield Enhancing Option Strategies Money Managers have identified several opportunities to enhance investment returns through the use of two general types of option strategies Targeted Buying and Selling allows an investor to take in income by executing a strategy consistent with their fundamental views • Targeted buying and selling • With specific investment targets, sell options and in return receive premium for a commitment to buy or sell at specific strikes. • Targeted selling: covered call writing/overwriting, sale of a call option on a current equity position • Targeted buying: covered put writing, sale of a put option on a desired equity position • Hedging • Protecting downside of existing equity positions

  6. Overwriting in Low Return EnvironmentRecent Press “How can an investor wring a positive return out of this grim equity market? These days some smart money is utilizing an equity derivatives strategy that first gained acceptance during the late 1970s: writing covered calls. Although no one tracks exactly how much money is going into covered calls, also known as options overlay, the approach is making a comeback. Industry observers reckon that about $5 billion in U.S. assets — roughly five times the level of just a few years ago — are tied up in the strategy. Several billion more are probably invested in covered calls in Europe.” Rich Blake, “Opt In,” Institutional Investor Magazine, September 23, 2002.

  7. Option Strategies - Selling Options Call Options Strategy: Sell Calls (Overwrite) - PM believes near- term upside in a stock is limited. Has a level in mind at which would be prepared to sell the stock should it continue higher. Sells a call option with a strike at this level and receives option premium as cash paym-ent. If at maturity stock price is below the strike price PM has enhanced yield/return by the option premium taken in. If stock price is above the strike price then the option will be exercised and the PM will be obliged to sell stock at the strike price. Put Options Strategy: Sell Puts (Underwrite) - PM holds stock or is looking to accumulate more. Has a level in mind for the purchase. Sells a put option with strike at this level in the stock and receives option premium as a cash payment. If at maturity the stock price is above the strike price then PM has enhanced yield/return by the option premium taken in. If the stock is below the strike price then stock option will be exercised and the PM will be obliged to buy stock at the strike price.

  8. Yield Enhancement StrategiesCase Study — Targeted Selling • Investor receives a premium for agreeing to sell an underlying equity position at a target price that is consistent with a fundamental outlook. • Expects stock to trade in a range, without significant downside risk, but believes there could be some limited upside potential. • Investor believes SAP upside is likely to be capped near term, but also believes downside risk is limited. • Sell Jun €90 calls on SAP for €2.40 bid vs. €74.50 stock. • This generates a 3.2% static return, and retains 24.0% of upside. • If stock rises to €90, target priced is reached, and equity position is sold at effective price of €92.40. Case Study SAP at €74.5, Sell Jun €90 Call for €2.40 Breakeven 92 Called Away Position Value Return 72 Stock Price Breakeven 72 92 Stock Price

  9. Investor gets "Put" stock, buys stock at ¥3,850 Position Value Breakeven¥3,674 Stock Price Yield Enhancement StrategiesCase Study — Targeted Buying • Investor receives a premium for agreeing to buy an equity position at a target price that is consistent with a fundamental outlook. • Wishes to purchase stock at attractive valuation, and sells a put at target purchase price. • Investor believes HONDA (¥4,050) is near its lows, and would buy the stock below ¥3,850. • Sell Jun ¥3,850 puts on HONDA for ¥176 bid. This generates a 4.35% static return. • If HONDA declines in price, investor gets “put” the stock at ¥3,850 – the price at which he agreed to purchase. The investor effectively buys the stock at ¥3,674 (¥3,850 minus the ¥176 premium). • If HONDA remains above ¥3,850 the investor retains the put premium as income. Case Study HONDA at ¥4,050, Sell Jun ¥3,850 Puts for ¥176

  10. Strangle Selling • VOD - Yield Enhancement • Strangle Selling - Example: PM neutral in VOD, would buy weakness, sell strength • The simultaneous sale of a call and sale of a put with identical maturity dates. The put strike is typically below the current spot and the call strike above the current spot. In a straddle , by contrast, the put and call have identical strikes (typically equal to the current spot) • Assuming VOD is trading at 126.25p the PM could sell the Oct 110p put at 2.5p and the Oct 130p call at 6.5p raising a total premium of 9p. If at Maturity VOD is neither below 110p nor above 130p then both options expire worthless and the PM has enhanced his/her return by 9p or 7.1% • The position makes sense if the PM believes that VOD is likely to trade in a pre-defined range for a period of time; or if the PM is a natural buyer of the stock at a given price below the current spot and a natural seller of the stock at a given price above the current spot. Breakeven of the strategy is equal to 101p on the downside and 139p on the upside

  11. VOD - Strangle Selling - Example

  12. Hedging Strategies There a variety of hedging strategies investors can utilize to protect individual positions, as well as the portfolio against downside exposure, thus reducing portfolio volatility • Put Buying, purchase of a put option to hedge downside risk • Collaring, purchase of a put option, financed by premium collected from the sale of an upside call option, to hedge downside risk • Stock Replacement, the simultaneous sale of long stock and purchase of call option to reduce downside exposure to stock

  13. Protected Below HK3.92 Position Value Stock Price HK4.375 Stock Price Hedging StrategiesCase Study — Buying a Put • Investor pays a premium for downside protection on a stock or index. • Believes a security could decline in value, and purchases a put option in order to hedge and stop losses at a particular price. Case Study China Unicom at HK4.375 Jun 4.15 Put Bought for HK0.23 • Investor believes China Unicom could decline, based on expectations of earnings risk. • Holds the stock, but would like downside protection. Is willing to take up to a 6% decline. • With China Unicom at HK4.375, buys a Jun 4.15 Put for HK0.23. This protects the portfolio from declines below HK3.92. • The long put requires up-front premium payment. This lowers returns in neutral to positive scenarios, and outperforms in lower return scenarios.

  14. Upside Capped KRW490,600 Protected Below KRW401,400 Position Value Stock Price Stock Price Hedging StrategiesCase Study — Buying a Collar • Investor wants to hedge downside, but believes that paying outright for a put is expensive. • Willing to limit upside return (sell a call) to finance the hedge. Case Study Samsung Electronics at 446,000 3 month Put KRW401,400 Bought 3 month Call KRW490,600 Sold • Investor believes that Samsung Electronics may decline, and also believes that it has limited upside until Jun 2003. • With Samsung Electronics at KRW446,000, buys a 3 month 90% Put for 3.19%. Also sells a 3 month 110% Call for 3.41%. • This requires no up-front premium • the call sold offsets the price of the put bought. Investor is protected below 90% and limited on upside return past 110%.

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