EQUITY BASKET SWAPS AND OPTIONS: PART I
GlobalCapital, is part of the Delinian Group, DELINIAN (GLOBALCAPITAL) LIMITED, 4 Bouverie Street, London, EC4Y 8AX, Registered in England & Wales, Company number 15236213
Copyright © DELINIAN (GLOBALCAPITAL) LIMITED and its affiliated companies 2024

Accessibility | Terms of Use | Privacy Policy | Modern Slavery Statement
Derivatives

EQUITY BASKET SWAPS AND OPTIONS: PART I

A financial basket contains a fixed portfolio of financial objects, such as bonds, and shares.

A financial basket contains a fixed portfolio of financial objects, such as bonds, and shares. For example, a portfolio of 1,000 shares of each stock in the Dow-Jones Industrial Average (DJIA) of Nov. 27 would be an equity basket.

Although baskets have many financial applications beyond the stock market, this article focuses on swaps and options involving baskets of shares. Part I, this week, emphasizes structures, and applications. Future pieces will discus risk management issues, and outline the theory of pricing equity basket derivatives.

STRUCTURES & APPLICATIONS

Buying a basket of shares is an obvious way to participate in the anticipated rapid appreciation of a sector of the stock market, without active management. A basket offers a combination of two contradictory benefits: focus on an investment style or sector, and diversification across the spectrum of stocks in the sector.

Individuals­except for the extremely wealthy­must settle for an off-the-shelf equity basket, such as a unit investment trust or a qualifying exchange-traded fund (ETF). Institutional investors can also buy equity baskets and derivatives made-to-order.

Mutual funds issue and retire shares to meet investor demand. Some mutual funds are equity baskets. Some aren't. Index funds keep the investment proportions nearly the same as the weights in the index, and these change glacially. An individual investor can buy a basket (approximately) by buying such a fund. However, the typical fund manager changes his portfolio composition actively. Such a fund is not a basket.

The ETF is a newer concept that the American Stock Exchange pioneered. By definition, an ETF is an investment fund--other than a closed-end fund--that trades on an exchange. ETFs that are in effect baskets of shares include SPDRs (Standard & Poor's Depositary Receipts), HOLDRS (HOLding Company Depositary ReceiptS), and Qubes (named after its ticker symbol, QQQ). SPDRs are claims on the basket of U.S. stocks that compose the S&P 500 index. The original issue of HOLDRS was a basket of the 20 largest pure Internet stocks when Merrill created the HOLDRS. Qubes track the Nasdaq-100 index. An equity basket by definition is not actively managed--buying an ETF where management can actively change stocks in the portfolio would not be a way to buy an equity basket.

BASKET SWAPS

Rather than buy a basket of shares, an institutional investor might enter into an equity basket swap, a contract that simulates the net cash flow of buying an equity basket with 100% funding. Transaction costs on an equity basket swap can be about the same as for the corresponding cash transaction, if the dealer does the cash trade to hedge his exposure. However, on rare occasions a customer can do better, if he accommodates the dealer's desire to trade out of an exposure. Hypothetically, a swap offers 100% funding without pledging security, but in practice the swap's terms often provide for collateral to mitigate counterparty credit exposure.

A basket swap may lack liquidity, because only the dealer can tear up the original agreement. Doing an offsetting transaction with another dealer leaves the customer exposed to the counterparty credit risk of two dealers.

BASKET FUTURES

Equity index futures contracts based on Laspeyre-type price indexes, such as the Standard & Poor's 500 index, are essentially cash-settled basket futures contracts, although the composition of the index changes from time to time. Equity index futures contracts tend to be more liquid than OTC products, with smaller transactions costs. However, they must compete with the variety of OTC products.

BASKET OPTIONS

An option on an underlying basket of shares is a lot like the corresponding option ­ e.g., call, put, barrier, or other exotic ­ on a single share, except that the basket replaces the share in the contract. For example, an equity basket call option provides the right, but not the obligation, to buy the equity basket at the strike price on the expiration date. Some basket options have physical delivery, while others settle in cash for the difference between the strike price and the market value of the basket.

Using an underlying basket, rather than just underlying mutual fund or closed-end fund shares, is significant. While the volatility of a basket may change over time, complicating the job of pricing a basket option, at least the composition of an underlying basket is not subject to moral hazard. For example, the manager of a diversified stock fund might buy an option of his fund's shares, sell off his more sedate stocks, and invest the proceeds in volatile and highly correlated Internet stocks. This would boost his portfolio's volatility and the value of the options. Obviously, OTC option dealers aren't going to participate in that game.

Equity basket options have selling points that baskets and swaps don't. For example: (a) An investor bullish on a sector but wanting downside protection may favor a call option on a basket of shares from that sector. (b) A trader who thinks the market overestimates a basket's volatility may sell a butterfly spread on the basket. (c) A relatively risk averse investor may favor a basket buy-write. (d) A trader who anticipates that the average correlation among different shares is going to increase might buy a basket option, hedge against a change in volatility by selling options on the component shares, and delta-hedge the remaining exposure to the underlying shares. Unfortunately, transaction costs can be prohibitively large, particularly when it comes to closing out an OTC option position.

A basket call warrant is a covered warrant if the issuer owns the underlying basket. An issuer of covered warrants typically lists its covered warrants on an exchange. This makes the product available to investors who cannot buy OTC products and increases the warrant's liquidity.

STRUCTURED NOTES

A structured note's coupon or principal payment may contain a basket swap or option, in effect. For example, a structured note's coupon may consist of a fixed component that is twice the market coupon and a floating component that is essentially a short equity basket call option. Such a structured note may make it possible for an investor to use a "fixed-income" instrument to profit--or lose out--from an opinion about an equity sector.

This week's Learning Curve was written by Bill Margrabe, president of the Margrabe Group (www.margrabe.com),a risk management and financial engineering consulting firm.

Related articles

Gift this article