Leverage & Derivative Products

Transcription

1 Leverage & Derivative Products Adam Cowperthwaite, Daiwa Capital Markets Hubbis Asian Wealth Management Forum 15 February 2011

2 When you combine ignorance and leverage, you get some pretty interesting results. Warren Buffett 1

3 Index What is Leverage? Leverage through Derivatives Is Leverage through Derivatives Risky? Recognising Leverage in Derivative Structures Estimating Leverage in Derivative Structures Using Leverage & Derivatives in PB Portfolios 2

4 What is Leverage? Basic investment leverage involves borrowing to invest in an asset. The cost of the investment is the interest paid on the loan. The investor s outlay is a relatively small interest cost, but this outlay gives access to a larger notional amount of the asset. The leverage employed gears the investor s exposure to any increase or decrease in the value of the investment, with respect to the investor s (relatively small) outlay. Scenario 1 Positive Performance Amount Borrowed / Invested Interest Paid Asset Performance Investment Profit Profit as % of Interest Paid USD 10m USD 0.5m +25% USD 2.5m 500% Scenario 2 Negative Performance Amount Borrowed / Invested Interest Paid Asset Performance Investment Profit Profit as % of Interest Paid USD 10m USD 0.5m -25% -USD 2.5m -500% 3

5 Leverage through Derivatives Derivatives offer leverage in the difference between the cost of the derivative (the premium) and a larger notional amount on which performance is calculated. e.g. A share costs $1, but an option on that share costs 10. An investor who invests $100 in shares can buy 100 shares. An investor who invests $100 in options gains exposure to the performance of 1000 shares. Derivatives allow an investor to buy or sell exposure to an asset, usually with a notional amount significantly larger than the premium paid or received by the investor. Derivatives can help an investor to modify the leverage within an investment or portfolio, and hence increase or decrease risk. The costs and potential losses from leverage are proportional to the amount and degree of leverage employed. Where options are bought, the premium spent can only be recouped from profits. Where options are sold, losses can greatly outweigh the premium received. 4

6 Is Leverage through Derivatives Risky? In derivatives products leverage can be used to increase or reduce the level of risk to the investor. The riskiness of the strategy depends on the amount and degree of leverage employed. Leverage Risk Leverage Risk Premium Paid Premium Received Buy Options: The more leverage obtained, the larger the potential profit. However, the more money spent, the larger the cost if the strategy fails. Sell Options: The more risk assumed, the higher the premium received. However, the more options sold, the larger the loss if the strategy fails. 5

7 Is Leverage through Derivatives Risky? Example 1. Mr Wong likes Hutchison (0013) and wants to invest HKD 5m. He thinks that the current price is quite high, however, and wants some downside protection. His RM suggests that he could buy the shares through an Accumulator. Mr Wong agrees and decides on a 12 month accumulator with a maximum notional of HKD 5m. Strike 92%, KO 110%. Q: Is this investment more or less risky than just buying the shares now? A: Through the use of leveraged instruments (KO Puts and Calls) Mr Wong achieves a situation whereby both his downside risk and upside potential are reduced, in comparison to a straight purchase of the shares. (NB - Unlike a cash investment, Mr Wong is not free to sell the 0013 shares at any time, since the delivery of the shares occurs only monthly. However, if 0013 performs poorly and he wants to exit the investment, he can unwind the accumulator, and his loss should always be less than that of an equivalent straight investment in the shares.) 6

8 Is Leverage through Derivatives Risky? Example 2. Mr Ho is bullish on Jiangxi Copper (0358 HK). He thinks that the stock is soon going to break to the upside. Normally, Mr Ho would simply buy the shares, but a friend recently made a large profit using digital options. Mr Ho asks his RM for a digital option on 0358 that will pay him HKD 1m if 0358 is up 30% in 3 months time. The option price is only HKD 100k, so Mr Ho executes the trade for 3x the notional, spending HKD 300k. Q: Is this investment more or less risky than just buying the shares now? A: Through the use of leveraged instruments (Digital Calls) Mr Wong has significantly changed the risk profile of his investment: A rise of >=30% would net Mr Ho a significant profit vs. the shares A performance of -30% ~ +29% would deliver a HKD 300k loss for Mr Ho even where there was a positive performance from the shares. A performance of <-30% by the shares would deliver a loss for Mr Ho, but his performance would be better than the shares, as Mr Ho s loss is floored at the HKD 300k premium that he paid. 7

9 Recognising Leverage in Derivative Structures Leverage through derivatives can be identified by reference to the amount and degree of the leverage: Amount relates to the absolute notional referenced by the structure. For example, if an investor sells 3x the notional of put options to finance 1x the notional of call options, a large amount of leverage has been employed on the downside. The amount of leverage employed would typically correlate with the amount of risk implied by the structure. A large premium paid or a large downside exposure taken on would both suggest a higher risk profile. Degree relates to the gearing of the structure. For example, if an investor pays a very small premium for an option with a remote probability of a high payout, the structure has a high degree of leverage. The degree of leverage employed would typically correlate with the extent to which the payout is speculative. This has implications for the utility of the investment within a conservatively managed portfolio. The amount or degree of leverage can be modified through non-vanilla risk features: worst/best of, knock-in/knock-out, time features, etc.. 8

10 Estimating Leverage in Derivative Structures An accurate appraisal of the leverage in a derivative product requires that any structure be decomposed into its component parts: Cash or Cash Equivalents [No Leverage] e.g. PV of capital guarantee or fixed coupons. Delta One [No Leverage] e.g. direct exposure to underlying assets Direct Leverage [Financed Leverage] e.g. physically-managed CPPI Bought Options [Long Derivative Leverage] e.g. participation in Capital Protected notes. Sold Options [Short Derivative Leverage] e.g. short put option in an ELN Once the component parts have been identified, leverage in the product can be estimated using the following rule-of-thumb tables: 9

11 Estimating Leverage in Derivative Structures Capital Guaranteed High Fixed Coupon Low Fixed Coupon High Maximum Payout High Degree of Leverage High Amount of Leverage Low Maximum Payout Low Amount of Leverage Low Amount and Low Degree of Leverage Capital at Risk High Maximum Payout Low Maximum Payout High Fixed Coupon or Large Discount to Par High Amount of Leverage (Downside) High Degree of Leverage (Upside)* High Amount of Leverage (Downside) Low Degree of Leverage (Upside) Low Fixed Coupon or Small Discount to Par Low Amount of Leverage (Downside) High Degree of Leverage (Upside) * Low Amount of Leverage (Downside) Low Degree of Leverage (Upside) * Most common scenarios. Could also imply High Amount & Degree of Leverage on Upside and Downside. 10

12 Applying Leverage & Derivatives in PB Portfolios Assess the portfolio profile and simple product requirements: Capital Guarantee or Capital at Risk Growth or Yield Client s market outlook, investment views and preferences Client s expectations from a new investment Client s real risk tolerance Select a derivative structure: Map the required cashflow profile, including coupons, capital protection or the acceptable maximum negative return. Compare the profile to vanilla investments use a structured product when cash investments will not efficiently achieve the same result. Use the cashflow profile to construct a derivative strategy using the simplest components and lowest amount and degree of leverage to offer the target return profile. 11

13 Applying Leverage & Derivatives in PB Portfolios Example 1. Mrs Tang believes that the retail sector may be due for a re-rating as consumer spending strengthens. She sees McDonalds as a bell-weather stock for global retail spending. Her price target is USD 95 in one year s time (+25%), but, given the 5% fall since December, she recognises the possibility that the US recovery could stall, bringing a sharp equity market correction. She asks for an safer alternative to buying the shares. The investment requirements are: short-term growth potential with limited downside. Mrs Tang wants less risk than shares, but a similar amount of performance. A 1-Year ATM strike call option on McDonalds would cost approximately 6%. The remaining cash would earn approx 1% in a risk-free asset. This combination would give Mrs Tang a net profit of 20% if MCD hits the target, and a max. loss of only 5% if MCD drops below today s price. The potential disappointment is if MCD s performance is between -5% and +5%, and Mrs Tang would have been better off buying the shares... 12

14 Applying Leverage & Derivatives in PB Portfolios Example 2. Mr Chu is a conservative, 40 yr old investor whose appetite for loss is very limited. He would like to increase the broad equity component of his portfolio but was badly burned when he bailed out of mutual funds at the bottom of the market in He generally has a long-term outlook and does not need yield from his investment. The investment requirements are: long term growth linked to equities and capital protection. While he could achieve his aim with zero coupon bonds and call options, it would be easier to put a simple 5-year capital protected note into his portfolio. The embedded option should be over a basket of major equity indices, and should be quantoed into his base currency to avoid FX risk. The potential disappointment is if some of the indices in the basket perform well but some poorly, and the overall return from the product is weak. The performance of the product during the lifecycle should also be explained to Mr Chu, to avoid any mid-term surprises. 13

15 Beware of geeks bearing formulas. Warren Buffett 14

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