Mohamed Bouzoubaa

Forwards, Futures and Swaps

Stock futures are standardized contracts where two counterparties agree to exchange a specified number of underlying stocks for a pre-agreed price (the futures price) with delivery and payment on a specified future date, the delivery date. In a futures contract, the party buying the underlying stock in the future is said to be long, while the seller is referred to as being short. These financial contracts are negotiated and traded in futures exchanges, which play an intermediary role between the long and short counterparties.

Inside the World of Equity Derivatives

In a bank, the sales team are the people facing the clients and discussing ideas and potential transactions with them. Sales teams represent the interface between banks or similar financial institutions and their clients. Sales teams can be segmented and organized by products and/or by geographical coverage. Meanwhile, relationship managers are, as their name implies, in charge of origination and client coverage. They are in charge of initializing and maintaining the bank’s relationship with its clients. They are less specialized than salespeople, but should frequently have conversations with local and regional clients to understand their needs, and should engage the appropriate salespeople to offer the optimum solutions and continue the talks on those specific subjects.

Pricing Vanilla Options

European equity options are financial instruments that provide the holder with the right, but not the obligation, to buy or sell an equity underlying at a pre-agreed price (the strike price) on a specified future date, the maturity date. It is the choice of the holder of the option to exercise their right to buy/sell the underlying at the strike price. The term “European” means that the exercise date may only take place on the option expiry date. European options can be standardized and exchange-traded or negotiated over the counter. The equity underlying could be a stock, a basket of stocks or a stock market index. Again, one can choose between physical and cash delivery at the inception of trade. Today, European options are widely traded by most market players, who are so used to their payoff mechanism that they call them vanilla financial products.

Yield Enhancement Solutions

Equity structured notes became very popular at the end of the 1990s; they were issued by banks in response to their clients’ investment needs. Equity notes are not usually used for hedging purposes. On the contrary, they are a response to a willingness to speculate on the behavior of a specific underlying asset during a particular period. The clients involved are hedge funds and institutions; and treasury managers of large corporations sometimes become interested in equity structured notes.

Strategies Built around Vanillas

A short covered call strategy is particularly appreciated by portfolio managers. Indeed, they can choose to adopt short-, medium- or long-term strategies. In the case of funds following longer-term strategies, they may need to keep their holdings when stock markets are going down. This does not happen without impacting the portfolio’s valuation; investors may feel uneasy in these situations, and thus may withdraw their money from the fund even if portfolio managers try to explain that it is part of their strategy, as they believe the market will bounce back. Therefore, portfolio and fund managers usually sell equity call options during periods when they believe the underlying stock will decrease. As the options’ time to maturity corresponds to the length of these periods, the premium they get for selling the call options would compensate for the unrealized loss from holding the underperforming stocks during that time.

Risk Management Tools

A portfolio or fund manager needs risk management tools to be able to quantify the risks inherent in the portfolio. Indeed, if the portfolio is composed of equity derivatives, then its value depends on the variations of the different parameters that could impact the market price of these derivatives. In the case of equity options, the premium is affected by several parameters such as the actual price of the equity underlying, the volatility, the expected dividends, the interest rates and the time to maturity. There exists a series of tools or measures that help the fund manager quantify the sensitivity of the different derivatives depending on the behavior of the above parameters; these are known as the “Greeks.”