Options and Futures: New Route to Risk Return Management

Foreword Darwin M. Bayston, CFA Vice President, Continuing Education

The unprecedented volatility of financial markets in the 1970's and early 1980's has led to the development of a host of new financial instruments - and the rebirth in new forms of some old ones. Of these new tools for investment management, none has grown faster or found broader use than options and futures. After only a short period investment managers in numerous areas of application have realized the important potential of these instruments for managing risk and return. Given the importance of options and futures to the investment process, the Institute developed and sponsored a oneday seminar, "Options and Futures: New Route to Risk/Return Management." It was first presented in Boston on December 15, 1983 and a second presentation was made in Dallas on February 16, 1984. As important as the seminar was to the attendees, the resulting proceedings serve an even greater purpose. Not only do they make a valuable contribution to the professional literature for members, but they also provide impor-

tant material for the CFA candidate study and examination program. The Institute extends its appreciation to the seminar speakers: Sumner Abramson, CFA, Putnam Management Company, Inc.; David M. Dunford, CFA, Travelers Investment Management Company; Paul H. Fullum, IBM Corporation; H. Nicholas Hanson, Salomon Brothers; Robert W. Kopprasch, CFA, Salomon Brothers; Lloyd McAdams, CFA, Security Pacific Investment Managers, Inc.; Patricia A. Owens, The Equitable Life Assurance Society of the United States; and Robert E. Shultz, IBM Corporation. A special thanks is also extended to Roger F. Murray, who provided valuable guidance to the development of the program and served as moderator. Thanks is also extended to James R. Vertin, CFA, Chairman of the Council on Continuing Education, O. Whitfield Broome, Jr., Executive Director, and Cathryn E. Kittell, Assistant to the Director of Continuing Education. Each of them made a significant contribution to the program and to this publication.

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Options and Futures: New Route to Risk/Return Management Sponsored by The Institute of Chartered Financial Analysts OVERVIEW OF THE SEMINAR Donald E. Fischer, CFA The enormous popularity of the options and futures markets is well documented. The CBOE began in 1973 with barely sixteen common stocks. By 1982 there were three other exchanges with listed stock options, and U.s. exchanges alone had about 9,500 different active option contracts on some 360 different common stocks. From the initial trades in 1982 the markets for stock index futures have grown to the point where the underlying market value of index futures traded regularly exceeds the market value of shares traded on the NYSE on a daily basis. The impressive list of statistics stretches on and on. But important questions linger about the role of derivative investment vehicles in the risk-laden world of asset and liability management. Corporate financial executives and institutional investors have been thrust into considering these derivative instruments, taken from what many view as an arcane and even alien world. Legislators, regulators, boards, clients, and others have lagged behind in their understanding and appreciation of an almost endless stream of new financial instruments, often evidencing a knee-jerk reaction to options and futures as pure speculation. It is essential to know how the use of op-

tions and futures alters risk/return relationships under a specific set of circumstances. A myriad of questions arise. What applications are appropriate that will contribute materially to the realization of conservative investment objectives? Which applications are patently inappropriate? Is the economic risk of entering into options and futures contracts measurably less than the risk of not doing so? This seminar brings together leading spokespersons who are actively involved in the use of options and futures. Their collective perspective contributes to a better understanding of the nature

of options/futures and how to use them to navigate new routes to managing risk and return. The seminar begins with presentations on the nature of optionslfutures, the participants in the markets, exchange operations, contract specifications, and pricing. These presentations are followed by in-depth discussions of options/futures strategies and their use in the management of portfolios. A unique perspective is offered through the eyes of a pension plan sponsor. The seminar concludes with a lively question and answer period. A brief summary of each presentation follows. FIXED INCOME FUTURES/OPTIONS The opening presentation by Bob Kopprasch provides some elements that have applications to both fixed income futures and options. Kopprasch tells us about the participants in these markets, exchange operations, the use of margin, and the importance of understanding contract specifications. We become aware of the particulars surrounding the pricing of futures contracts through examples using both Treasury bill and bond futures. Kopprasch then turns to specific applications of futures and options on fixed income securities. We learn that futures allow us to change risk characteristics of available securities, to modify duration, and to pre-invest by purchasing now to lock in today's rates. Financial futures also facilitate the hedging of assets and, perhaps most importantly, they offer market liquidity that is without parallel in the cash markets for corporate or even government securities. The uses of fixed income options are conveyed to us by looking at insurance companies and the options they typically give and receive. Kopprasch suggests that knowledge of the options in the products they offer, and the options contained in their asset portfolios, is a key to the use of options by insurance

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companies. The options markets might be used to determine the cost of what is being given away; it might be possible to buy options to offset those granted in products. It may be possible to combine options granted with other options to alter the risk profile. Bob closes his presentation by cautioning that occurrences in the cash markets are not exactly mirrored in the futures markets. Believe the futures market when it tells you what rate you can lock in. But don't think that rate is the cash rate.

EQUITY FUTURES/OPTIONS The second presentation, by Nick Hanson, provides us with valuable insight into equity futures contracts and options on these futures contracts and options. Hanson tells us about some of the participants in these markets, and important contract specifications. We learn that about one-half of the trading volume is accounted for by locals trading on the floor of the exchanges. The contracts available require cash settlement, there is no delivery, and variation margins are required to preserve integrity iJ:"l the markets.

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Institutional investors find stock index futures useful in many ways. These contracts can be used in index fund management and for rapid, efficient alteration of the equity exposure of a portfolio. Stock index futures allow portfolio managers a major opportunity to separate stock selection from timing; and once this separation is accomplished, market timing strategies can be accomplished in a very costeffective way. Hanson also points out that futures can be used in dynamic portfolio insurance programs rather than selling stocks and going to cash. Futures are effective vehicles in dividend capture programs and have uses in reallocating assets between pension fund managers. Hanson turns next to the pricing of stock index futures. This complex subject is made very clear through some easy to understand arithmetic and examples. The essence of pricing, we learn, is to view the futures price as dependent upon the cash price plus the difference between the expected dividend on the index and the risk-free rate of interest.

This difference is the cost of the carry. Hanson reminds us tha t pricing in equity futures contracts is not as efficient as it is in the fixed income markets discussed by Bob Kopprasch. Mispricing exists because the underlying instrument for one of these contracts is not easy to deal with (e.g. an unwieldly 500 stocks) and also due to problems related to the up-tick rule. Futures contracts differ from option contracts since a futures contract is not a right but an obligation. Futures prices can be calculated on a cash and carry basis, but options differ because of the insurance premium built into the price. Options and futures valuation depends upon many of the same things with the crucial difference being the sensitivity of the option's value to the volatility of the underlying instrument. Futures simply involve delaying payment. Options permit the buying and selling of volatility.

OPTIONS IN PORTFOLIO MANAGEMENT The foundations of markets, contract specifications, and pricing of futures and options are nicely articulated by Kopprasch and Hanson. They also enumerate some general areas where options and futures can be used. Next, the discussion shifts to more specific examples and insights into the uses of these contracts by portfolio managers and a view of these new tools from the perspective of plan sponsors. Sumner Abramson turns the focus to the use of options in portfolio management. Abramson reminds us that options are really devices for transferring risk. This risk transference capability can assist a portfolio manager in achieving some specific objective, either as just another investment arrow in the quiver, or in managing a dedicated program. To underscore the use of options to achieve a specific objective, Abramson points out the development of the options income fund, which was an attempt to set up a better income fund outside of traditional fixed income vehicles. We are made aware of three uses of options in portfolio management: buy-

write, overwriting, and 90/10 programs. Buy-write programs using inthe-money call options increase returns while providing downside protection through risk transference. Abramson indicates that in buy-write programs it is reasonable to shoot for a return oneto-two percent above the S&P 500 with about two-thirds the volatility. Overwriting has an objective of incremental return. It is similar to stock lending in that you are using an asset that is essentially sitting idle. A pension fund administrator might hire an options manager to sell options on an equity portfolio managed by someone else. The general stipulation is that options cannot be exercised. A 90/10 program allows you to place ninety percent of your assets in money market instruments and the remaining ten percent in long calls or puts, depending on whether you are bullish or bearish. The interest earned on the money market component presumably will cover losses in the call/put portfolio. Abramson closes by cautioning that options are merely derivative instruments. The single most important part of any program is the underlying security, even if that underlying security is cash. THE PLAN SPONSORS' VIEW A major ingredient in the Seminar was the participation of a pension fund administrator or plan sponsor. Bob Shultz and Paul Fullum focused on conceptual uses of stock index futures. In their organization, investment managers are permitted to make the decision to use futures in enhancing their ability to execute strategy-but the basic issue is still the value of their investment insights. Shultz and Fullum begin by looking at the potential deficiencies of the multiple manager structure and environment. The primary role of an investment manager in a multi-managed fund is to provide superior return. There is no need for a plan sponsor to pay for diversification. He can do it himself-cheaply, almost mechanically. A multi-manager environment can tend to dissipation of best results and lead to overdiversification at high fees. Also, a

lack of risk control can develop as the aggregation of strategies ends up dictating total portfolio risk and a tendency develops towards "closet indexing". The key deficiency is probably when the manager's business risk overrules investment risk. The point is made that the use of options and futures as a stand-alone strategy misses the whole point of the exercise. The presenters argue that these markets offer the potential for hedging away market risk and unintended exposures which may well account for 98 percent of total risk. The other two percent is where the attention should be focused. They contend that the general failure of plan sponsors to succeed in getting managers to be more aggressive and to take more residual risk comes back to the rational behavior of these managers relative to their own business risk. Managers measured against a broad market index behave rationally in not taking more risk. Plan sponsors tend to create this reaction to risk taking when they measure managers against a market index. Plan sponsors use futures and options in numerous ways. These vehicles can be used for arbitrage in trading back and forth between cash and futures. Futures can be used in asset allocation and timing decisions where the sponsor wants to gain control over the asset mix without taking decision making away from managers. Sponsors may find that a working cash level does not represent the aggregation of policy decisions. They can take this money and put it in a short term investment fund with stock or bond futures. Plan sponsors might use futures and options for risk control. The sponsor may want to hedge unwanted risk exposures to factors and sectors or implement biases (e.g. increase small stock participation). Also, risk control can involve completion holdings where you wish to correct sector under-representation that is apparent when your multiple portfolios are aggregated. The ability to control systematic risk is probably the most powerful motive in terms of plan sponsors. Without getting the manager to take more risk, you can put on a hedge to move the market out of

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his risk/return position. The manager is not doing anything differently, but you are making what he is doing more important to you by putting on the hedge. Futures and options can also be effective in portfolio liquidation, say, as opposed to a guaranteed price incentive trade. You are able to move a lot of money, unknown to the marketplace. Unless plan sponsors recognize problems inherent in a multiple manager portfolio, uses of options and futures will not become readily apparent to them. MODIFYING PORTFOLIO CHARACTERISTICS USING OPTIONS Lloyd McAdams turns the attention of seminar participants to two critical points. First, the most difficult problem for managers using options might well be explaining to clients why the use of options is good for them. Second, options represent a new way to adjust portfolio risk/return relationships. The conventional wisdom has been that you alter the risk/return relationship in a portfolio by adjusting the cash/stock/ bond mix. Portfolio return characteristics can now be modified using puts and calls.

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The "mother" of option strategies is the writing of covered calls at-the-money. You want to earn a rate of return significantly in excess of the risk-free rate over a full market cycle, and can tolerate interim-period negative rates of return. However, you don't get material risk reduction during periods of market weakness. Covered calls in-the-money give an expected return below that of the atthe-money alternative. You use them if you are very risk averse and can't, during interim periods, accommodate material declines in stock prices. The appeal is that an in-the-money strategy can offer expected returns above the risk-free interest rate. This is often a strategy substitute for an investment in fixed income securities. McAdams then turns his attention to combined put/call strategies. Strategies where you are long the stock and long a put afford substantial returns when the

stock appreciates, while providing a fixed maximum loss. A negative factor is the inability of taxable investors to earn long-term capital gains on the stock on which the put has been purchased. Put/call combinations are very effective in risk control. An absolute downside loss maximum can be achieved that is not possible with futures. An important strategy is one involving a covered call, long put using split strike prices. It is possible to construct this strategy and end up with a positive return at all levels of stock price. This result has traditionally been associated basically with Treasury bills or commercial paper. This strategy leads to a nonlinear risk/return adjustment-the whole key to separating options from futures. Options are non-linear. Lloyd concludes by putting the strategies together. The keys to appropriate options strategies are premium levels and your outlook for the market. For example, a positive market outlook coupled with high premium levels suggest that the best strategy is to own the stock. Calls might be purchased in a positive market environment with relatively low premium levels. It is important in setting strategies to examine the outlook and premium levels in individual market sectors. Sometimes you may have stocks on the put side in one sector while you are doing nothing with stocks in another sector. McAdams closes with the reminder that the best results come to the manager who already knows where the stock will be on the expiration date! MANAGING FIXED INCOME PORTFOLIOS WITH FUTURES AND OPTIONS Next up is Pat Owens. Her talk zeroes in on some case situations where futures were used in a hedging capacity. She presents three interesting case histories. The first involves a small pension fund. The company wants to avoid further contributions to its plan so that it can use cash flow to expand the business. They are able to accomplish this goal with an 80% fixed income/20% equity portfolio allocation using hedging

strategies to protect market value changes on the fixed income portion. Knowledge that the fixed income return is fairly predictable permits very aggressive management of the equity funds. The second case involves a medical insurer. This company wants a backup pool of assets for meeting underwriting claims. They seek separate pools of liquidity, each having a different degree of risk. In one pool hedges are employed by selling futures against a bond portfolio. The start of the process involves eliminating holdings that are not hedgeable in order to minimize basis risk. Holdings that are highly hedgeable, such as Treasuries, are hedged 100%. The remaining portion of the portfolio is managed using market timing with hedging applied as the market moves up or down. The final case deals with applications in the insurance business-protecting guaranteed rates, and forward commitments. GIC contracts usually involve the guarantee of a rate to the client. There is risk between the time of the guarantee and receipt of the money as interest rates move about. These contracts typically lend themselves to long hedges which are anticipatory in nature. As soon as you know when the money is coming in you can buy enough futures to secure the market change. Forward commitments, such as private placements, are not always easy to find and generally take some time to close. There is risk in these commitments of a rise in rates before the deal is closed. Short hedges (long bond, short futures) are best suited to these cases. Owens reminds us to be aware of the dynamics of hedging. It is important to be aware of such matters as convergence, the shape of the yield curve, and the necessity to be prepared to roll contracts with the passage of time. Finally, she suggests that hedging may not always be the correct thing to do and that there are degrees of hedging. However, hedging should not simply be rejected as expensive, inefficient, or arcane for it can and does make a difference in portfolio performance.

STOCK INDEX FUTURES: A PORTFOLIO STRATEGY TOOL Dave Dunford concludes the formal presentations with a discussion of the role of stock index futures as a strategy tool within the total process of portfolio management. Dave reminds us that there are four general strategies for maximizing the return of a portfolio-passive, active, insurance, and implementation. Options playa role in insurance strategies. Insurance is bought (sold) if options are purchased (sold). All strategies-passive, active, insurance-must be implemented. The effort in implementation is directed at minimizing transaction costs, including commissions, market impact, transaction time, and portfolio disruption. The use of futures contracts permits drastic reductions in commissions, and the market impact is mitigated due to the greater relative liquidity in futures markets. This same relative liquidity shortens the time to buy/sell positions and minimizes portfolio disruption. Dunford next directs his attention to five specific portfolio applications of stock index futures. The first application deals with index funds. Futures provide a superior method of constructing an index fund due to lower transaction costs, the ability to purchase the entire index (all 500 of the S&P stocks, not a subset), and avoidance of dividend reinvestment. Stock index futures facilitate the handling of large cash contributions to an existing portfolio. Buying common stock to gain a target level of representation via futures does not consume nearly the amount of time taken by more traditional methods. Time is the enemy during major market moves, and can lead to penalties as the manager attempts to move up to an intended level of investment. Dave points out that futures allow us to control the beta level in a portfolio. For example, suppose a manager wants to elevate the portfolio beta from an exist-

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ing 1.1 to 1.2. One method, of course, is to sell low beta stocks and reinvest the proceeds in higher beta stocks. Another approach is to buy an appropriate amount of stock index futures to increase the portfolio beta. The next application Dunford presents involves asset allocation decisionsactive judgments of stocks versus bonds. It is possible to lower equity exposure and increase bond exposure by selling stock index futures and purchasing Treasury bond futures. An important side benefit is the reduced commitment of funds necessary in the implementation of this strategy due to the leveraged nature of futures contracts. The final application relates to high turnover strategies. For example, strategies based upon put replication involve hedge ratios. High turnover results from continuously changing hedge ratios. The cost of implementing this technique can be greatly reduced by increasing or decreasing market exposure through buying and selling stock index futures. Dave concludes by suggesting that futures add to the incremental return of a portfolio through lower commission costs, immediate implementation of the portfolio strategy, a lower market impact or cost due to execution and finally, minimization of the disruption within the portfolio.

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THE FUTURE: SUMMARY OF PANEL QUESTIONS/ANSWERS The seminar concludes with a lively question and answer period with all the speakers on board. The following summary captures the essence of the interaction: Market Liquidity The panel is asked whether liquidity will improve beyond the near term contracts (closest to maturity). These near contracts are the most liquid primarily because of heavy dealer participation. The sentiment is that contracts beyond three months will increase significantly in liquidity. This will be facilitated by the breakdown of institutional barriers

and as unique sets of managers enter these markets with unique sets of objectives. It is also noted that there may be more liquidity in the distant contracts in bond futures than meets the eye. This may be evidenced by the active spread market in these contracts. Performance Measurement How are performance measurement systems being adapted to cope with the use of options/futures? The questions relate both to traditional measurement parameters (time-weighted returns, beta, etc.) as well as standard accounting for profits. The responses suggest that systems in place will, unle$s altered, become pretty obsolete. Both the traditional measurement services and the options societies have yet to develop a successful performance measure for the options manager. Further, it is suggested that most master trust banks seem to be grappling rather unsuccessfully with the basic issue of simple accounting for profits. It is not clear that traditional reliance on the standard deviation and its offspring, such as beta, is relevant with the advent of options. Option and insurance strategies introduce skewness in the distribution of returns. When you are trying to combine options with an asset class having a normal distribution, you need to move towards a broader picture of the outcomes.

Outlook for Sector/Industry Futures What is the likely development of additional sector futures contracts and the likelihood of improved liquidity in these sub-indexes? In addition, the point is raised concerning the need for a broader range of sub-indexes as requisite to promoting a high level of activity (e.g. to accommodate sector rotation in equity management). The consensus suggests that this entire area is going to expand. The desire to generate more commissions and fees has presently led to such a proliferation of new products that a temporary moratorium is in effect. The computer technology index has been very successful. The lack of popularity of the

energy index may simply relate to the fact that the entire group is currently out of vogue. There have been interesting proposals to include a futures contract on the CPI (consumers price index) so that analysts can back out expectations relative to the real rate of interest. What's left for Bonds? What, then, is the future role of bonds, since it would appear that futures and options provide alternate means to diversify or hedge equity exposure? Will bonds be relegated to the position of trading vehicles? The feeling is that bonds will have a long-term asset allocation role so long as they enjoy low correlation relative to stocks. However, it is suggested that op-

tions strategies in the hands of a good equity manager might provide a good alternative to bonds. Will options on futures eliminate options on actual bonds and is a futures contract on a market index for fixed income securities a prospect? We are told that traders have generally expected options on futures to prevail because they are more liquid and also avoid certain potential delivery problems. There has been talk of a futures contract on a market index for fixed income securities with the usual disagreements on what index actually represents the fixed income market. Perhaps Treasury bond futures can be viewed as a market index contract even though they do not capture quality spreads.

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Options and Futures: Strategic Tools for Portfolio Management (Part n Robert W. Kopprasch, CFA

My presentation includes comments applicable to both fixed income futures and options, as well as some discussion regarding contract pricing, how contracts are traded on the exchanges, and the function of margin. Many of the principles presented can also be applied directly to the equity side. The fixed income market has been characterized by a very active cash market. While perhaps not as visible as the equity market because it is an overthe-counter, dealer-traded market, many billions of dollars worth of securities are traded every day. In 1975, futures trading on GNMA contracts began and several additional futures contracts were added shortly thereafter. More recent developments include options on the cash market and on futures. At present, the most actively traded fixed income option contract is an option on bond futures (Figure 1).

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In December 1980, the Kingdom of Sweden issued a bond with warrants that allowed the purchaser to buy another bond, as opposed to the traditional right to exchange the warrant for common stock. This was the first true bond option, with a six-month life. As it turned out, the option expired worthless. By 1982, we had exchangetraded options on bonds and options on futures. So, a number of developments have changed the way both asset and liability managers can manage their portfolios.

Motivation to Use Future/Options What is a futures contract? A futures contract is a legal commitment to buy or sell a security. The instrument provides for the holder to either take delivery or make delivery of a security at some date in the future, much like a forward contract. The price is essentially determined today, as in any forward trade in the bond market. One of the most important features of futures contracts is the offset capability. Typically, when you enter into a contract and want to get out of that contract, you have to negotiate with the other original party. The futures market has a mechanism that allows you to offset your position by doing a reversing trade. This is very important for hedging and for a number of other applications. There are now a number of actively traded futures contracts in the fixed income market: U. S. Treasury bills and bonds, GNMA's, CD's, Eurodollar deposits, and U. S. Treasury notes. So, there are a number of places on the yield curve and several different credit qualities for which you can utilize futures contracts. Why do we use them? We can use them as an alternative investment. We can buy futures instead of buying bonds. We can construct combinations of cash and futures that look like money market instruments. We can use futures to hedge interest rate risk. There are also any number of arbitrage possibilities.

Figure 1 The Expanding Long-Term Debt Market PRE-1~}75

Bonds

1975 Bonds GNMA Futures

1977 Bonds GNMA Futures Treasury Bond Futures

1980 Bonds GNMA Futures Treasury Bond Futures Bond Warrants

1982 Bonds GNMA Futures Treasury Bond Futures Bond Warrants Options on GNMAs and Treasury Bonds Options on Futures Contracts

We won't discuss arbitrage in depth because it can get very complicated, but we will discuss arbitrage in the pricing sense because it has a major impact in terms of why the contracts are priced as they are. Typically, at least on a retail level, the motivation for using equity options is to employ leverage or to limit loss. In the fixed income market, however, leverage was available before options became available. In the futures market, or by using margin, government securities can be purchased with only 5 or 10 percent down. There is a lot of leverage available without options. There are several reasons for considering the use of fixed income options that are very different than the reasons for using equity options, for instance, when certain commitments made by an institution or corporation are tied to interest rates. These might be mortgage commitments, some sort of a forward market in which you've committed to take down some securities, or an insurance company that bids on a guaranteed investment contract (GIC) but doesn't receive the funds until some time in the future. These commitments are all tied to interest rates. A second situation involves foreign investors who can take a position in U.s. interest rates by using fixed income options (or futures) with very little currency exposure. Finally, market volatility can be exploited by using options, which cannot be done with futures or just the cash instruments. Participants and Exchange Operations The participants in futures markets are essentially everybody: hedgers, brokerdealers, and speculators. Who are the hedgers? They include corporations, mortgage bankers, commercial bankers, insurance companies, pension funds, bank trust departments - anybody with assets or liabilities that have a value related to interest rate fluctuations. Regulatory climates have changed over the last several years, making it far easier for some types of users to enter the market directly. The clearing house operation of the futures exchanges is something that is unique to futures and options and it

does not have a corollary in the normal equity market. It does have a parallel in equity options but not on the stock exchange, per se. Consider the following scenario. Client A comes to his broker and says, ''I'd like to buy a futures contract," and that order is routed to the trading floor. Let's say it is at the same time that Client B directs an order to the exchange floor. So Broker A and Broker B come to the pit on the exchange floor, there is some discussion on the pricing of the contract and a long and short position is established for the respective parties. At that moment it appears that Client A and Client B have obligations to one another. But, as they settle these trades, the clearing house becomes the "other party" to every trade. It steps into the middle of this trade and takes on an obligation to Client A. Since Client A bought the futures contract, the exchange says, "Weare ready to obtain delivery if you want." To Client B, who sold the contract, the exchange clearing house says, "We will take the securities if you are short in the end and we will make sure that you get paid for those securities." So, the exchange clearing house becomes the other party in every trade. This is very important because of the offset capability it provides. Client A doesn't have to find Client B in order to get out of this contract. He simply goes back through the exchange clearing house, does a reversing trade, and the position is wiped off the books. The result of the clearing house role is financial integrity. It has been fairly well publicized that, while people can lose a lot of money in the futures market, nobody loses money because of a default on the futures contract. Observing the trading on the exchange floor, it is very difficult to understand how they can reconcile any trades by the next morning before trading begins again. There are traders buying and selling who simply tear the pages from their pads as they close a transaction and throw them over their shoulders to their runners. The runners grab the papers from the air or from the floor and run them back to the desk to make sure that a confirmation is initiated. It is mind-boggling that this market can work, but billions of dollars in Treasury

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bill and Treasury bond futures are traded on it every day. Margin Although margin seems to be an inconvenience to just about everybody who trades futures, it is a very important factor. You wouldn't want to engage in a transaction for forward delivery with someone on the other side when you have no idea about their credit. In fact, you don't even know the identity of the other party the way the market is structured. So, you don't want them to have a large obligation to you. Margin prevents disaster. The initial margin is put up essentially as a safeguarded deposit just to show that you have some cash and can stand up to a couple days of losses in the futures market. Maintenance or variation margins come about as the markets move. Rather than let a large profit or loss develop, gains and losses are markedto-market every day. It doesn't count for tax purposes, but in a cash sense futures leave no unrealized gains or losses. It is as if all trades are liquidated every day at the closing price and then opened up the next morning at last night's closing price. You are always "flat" in the futures market. Large losses cannot develop as you don't owe anyone money after you settle up on the margin and they don't owe you anything. This protects the integrity of the market and eliminates the possibility of not being able to complete a trade because of an inability to execute on the part of the other party.

10 Contract Specifications It is very important that you get involved with contract specifications if you intend to trade in the futures market. Treasury bond futures are one of the more complicated; GNMA's are even worse. Some of you may have seen a Forbes article recently about delivery problems of GNMA's. You need to know the details of the contract specifications to operate effectively. Treasury bonds can be delivered on virtually any business day during the delivery month. If you are short the contract (that is, you will be delivering securities), you pick the delivery time.

Suppose December is the delivery month. You can deliver on December 2, December 17 -or on most other days during that month. You can also pick the specific bond to be delivered. Will it be the 9-1/8's, 10-3/8's, 12's, or 14's? You get to pick. The party with the long position on the other side does not know how much cash he is going to have to come up with to take delivery, or when he will get delivery. Only a notice a day or so in advance of the delivery date will enable him to figure out how much cash he will need. As you can see, you have to learn the contract specifications before you can trade the market. It sounds fairly obvious but inattention to some of the details of the contract specifications have left some people very sorry. Pricing Pricing is an aspect that has applications both to the fixed income and to the equity sides. Let's look at the pricing of a U. S. Treasury bill futures contract. Such contracts simply call for the delivery of a 90, 91 or 92-day bill. Let's assume it to be a June 15 bill. Let's also assume that we can sell a three month futures contract that requires the delivery of a three-month bill if we hold the position to delivery. If in December we sold a March futures contract, which requires delivery of the June bill, three months from now when the March futures contract goes to delivery, the June bill will be the deliverable bill. We can simply deliver it as the required security. We know what the six-month bill costs us today, so we have a known purchase price. When we short the futures contract, we are essentially selling that bill forward at a known price. With a known purchase price and a known selling price, we have both a known dollar and percentage return over the three-month period. What if that return were 12 percent? Everyone would do this trade. That would be the best three-month return that is available and it would invite arbitrage. However, it never gets to 12 percent in this kind of an environment. One of the major aspects of futures pricing is that you don't price the futures contract on expectations. The three-

month contract is not priced based on where people think three month rates will be in March, except insofar as that is already taken into account in the yield curve and the forward rate curve based on this simple arbitrage. Knowing that one can create a three-month instrument today should create a competitive three-month rate of return. Table 1 shows an example where Treasury bills due June 14, 1984 on a trade date of December 13, 1983 were selling at a discount quote of 9.15%. The bill could be purchased at that rate. The futures contracts that go to delivery on March 15, 1984 had a quote of 9.48%. Buying the six-month bill and selling the futures contract with the proper ratio, upon delivery the CD (certificate of deposit) rate of return would be 9.26%. The returns can be determined by Treasury bill math. It is easy if you know the 9.15% discount to come up with the price of a six-month bill of 95.323. Based on a futures price of 9.48% you can come up with a selling price of 97.604. There is a holding period of 93 days (184 - 91), so you simply take a purchase price of 95.323, a selling price of 97.604, and turn that into a CD return of 9.26%. The type of arbitrage employed would depend upon the rate. The return should generally be between the three-month bill rate and the three-month repo rate.

There is no specific rate of return on a "cash and carry" T-bill transaction. The full faith and credit of the U.S. government is not behind this three-month instrument. You have bought a sixmonth bill and sold the last three months to someone else. You do have the credit of the Clearing Corporation, but that is clearly not the same as the government's credit. So the rate should be higher than the rate available on bills. Yet, the contract is more liquid than repurchase agreements, so the rate should probably be somewhat lower than the rate on repos. Typically, the rate will fluctuate back and forth between the repo rate and the Treasurybill rate. Getting a little more complicated, let's look at bonds. Assume that on December 13, 1983 we buy u.s. Treasury 12's of 2013 and sell the futures that require delivery of that bond on March 21, 1984. We know the bond's quoted market price and what we have to pay in accrued interest on the purchase. We also know the selling price based on the bond futures contract, and the amount of accrued interest we will receive when we deliver the bonds. Collectively, this information gives a known capital return including the change in accrued interest and also any coupons that might be received in the interim period. Thus, we can calculate a guaranteed 6.04% return over a short-

Table 1 CST T -Sill Cash & Carry with 6/14/84 T -Bill

Cash Purchase Price = 9.15 discount [1]

$ Discount = 9.15 x 184/360 = 4.676667

Price = (100 - 4.676667)

[2]

[1]

Settlement for Cash: 12/13/83

$ Discount = 9.48 x 91/360 = 2.396333

[2]

CD equiv. return:

12/13/83 to 6/14/84 = 184 days

= 95.323333 3/15/84 to 6/14/84 = 9fdays

Price = (100 - 2.396333) = 97.603666

(97.603666/95.323333 - 1) x 360/93 = 9.260%

11

term period. Contrary to the Treasury bill example, this return may not appear to be competitive. This is due to all of those delivery options mentioned earlier with regard to the short; that is, whoever has sold the bond futures contract has the right to select what and when to deliver. And, there is also what they call the "every afternoon put." The futures market closes at about 3:00 p.m. and the settlement price is determined at that time. But the cash market continues to trade.

return is calculated. Buying the bonds with interest that has accrued, the cost is $104,600. In February a $6,000 coupon is received because this is a February/August bond. The coupon is then reinvested at a 9 percent rate for 35 days to earn $51.78. Adding the $1,154 accrued interest to the $99,133 selling price, the selling proceeds are $100,287. Annualizing the total profit of $1,738 over the cost of $104,600, and using a 99-day holding period gives a 6.04 percent floor return.

If you are long in the cash market, have shorted the futures and promised delivery, and the cash market falls drastically in the afternoon, you can still deliver at the 3:00 p.m. settlement price on futures. That opportunity is especially valuable on Thursdays after the money supply announcements are made. It is also valuable owing to some ratioing that is necessary because of the way the contracts are structured. Usually, you are short more contracts than you own pending delivery.

It is crucial in futures to understand this "cash and carry" pricing relationship. If it were not for the delivery options on the bond contract, the cash and carry return would be a competitive threemonth return. It becomes very important to understand that when thinking about hedging. For example, it is a common misconception that you can buy a long Treasury or a corporate bond, sell futures against it to protect the price, wind up earning the 12 percent return on the bond and still protect the price. This means getting a longterm rate for a short-term period. It simply can't be done. Proponents of this theory do not understand the forward rate curve. They do not understand, as the figures in Table 2 indicate, that while you buy the bond at 100, when it goes to delivery, you deliver at 99: the price loss (or gain if the yield curve is inverted) combines with coupon income to give you the short term rate.

In addition, there is a so-called "wild-card" period in bonds. About a week before the end of the month, the bond futures contracts stop trading, but the final delivery date is still one week away. The party that is short has a full week to determine when and what will be delivered. This can become a very valuable option.

12

In the example depicted in Table 2, the March bond contract is trading at a price of 69 18/32. If we were to buy the bonds to sell on March 21, we would have paid 100 22/32. Based on the conversion factor, we would be delivering them at about 99 4/32. It may seem ridiculous to buy the bond over par and sell it at that much of a discount, but the bond is carrying a 12 percent accrual rate in a 9 or so percent environment. With this income accrual a little bit can be given up in price and a reasonable return still achieved. If there is no spread at delivery and the bond is simply delivered, the worst return possible is 6.04 percent. That is, if none of the delivery options become valuable, this is the absolute floor return.

The data in Table 2 show how the floor

Futures Applications Let's now examine briefly futures and options applications. The previous application involved a thirty-year Treasury bond that was turned into a threemonth investment. Obviously, the risk characteristics of the securities that are available can be changed. Similarly, the duration of a portfolio can be modified and increased beyond what seems reasonably available in the market by buying futures. Duration is in one sense a measure of volatility. In a futures contract with no real investment up front, you are just adding volatility to the portfolio or selling it off. In the example, a 12 percent bond due in 2013 was modified to an instrument having a duration very close to three months.

Table 2

CBT T -Bond Cash & Carry with US Treas. 12's of 8/15/13 Cash purchase price Futures price Conversion factor:

[1]

10022/32 6918/32 1.4251

Settlement for purchase: 12/13/83 Settlement for futures delivery: 3/21/84 Days from settlement to maturity = 99

Buy Govt for 100 22/32 = on 12/13/83

100,687.50 3,913.04

principal accrued

104,600.54 [2]

Receive coupon of 6,000.00 & reinvest for 35 days at 9.00% bond equiv. on 2/15/84 6,000.00 x 0.09 x 35 51.78

-

6,000.00

365

6,051.78 [3]

Sell Govt for 69 18/32 = x 1.4251 99.133519

[4]

99,133.52 1,153.85 100,287.37

Total Profit: 100,287.37 6,051.78 -104,600.54 1,738.61

[5]

Breakeven repo rate: 1,738.61 X 104,600.54

360

6.04%

CD return

99 or to earn a short-term rate plus a longterm spread.

A second use of financial futures is the ability they give to pre-invest. That is, you can buy now and lock into today's (forward) rates or today's (forward) prices. Pre-investing might involve forward GIC commitments, pension fund contributions, or market timing decisions. A number of insurance companies have been using forward transactions in order to accomplish a protection goaL That is, they will get a quote on a Treasury bond for delivery in February w here the pricing is determined almost exactly the same way. We (Salomon Brothers) buy the bond and finance it for three months. If there is a financing profit we give that back, if there is a financing loss we charge for it. So the "carry" is built in just as it is with futures contracts.

Futures offer market liquidity. Millions of donars worth of securities in the futures market can be transacted without adversely affecting the price, something that can't be done in the corporate market, or even in the government market, quite so quickly. Volume in the bond futures market is greater by a substantial margin than volume in the cash market. If you have $30 million worth of securities that you'd like to get rid of quickly, you may not be able to go into the cash market and do it right away. But, you can sen a surrogate for it in the futures market. Futures allow you to implement your timing decisions before you have made your selection decisions.

Financial futures can also be used to hedge assets. This use might seek to minimize fluctuations of market value to assume a defensive market posture,

Futures can be used to modify duration, whether in an immunization or a contingent immunization mode. If you want to back up a shorter GIC with

13

longer securities you can modify the duration in futures, changing its risk characteristics. Or, you can go out and buy bonds that have desirable coverage, sinking fund, call features, and maybe attractive spreads and use futures to modify the duration instead of buying bonds that have the necessary durations, but otherwise less desirable characteristics. Finally, I'd like to talk about earning a short-term rate and a long-term spread. What we looked at before involved owning a 12% Treasury bond and shorting the proper number of futures contracts to give us the short term rate. Suppose that instead of owning Treasury 12's, you owned a corporate security earning a spread over the 12% Treasury rate, and shorted futures contracts. If there was no change in spread over the horizon, you could assume that you would earn the short-term rate plus the spread over a long government. However, spread changes over the horizon can influence your return drastically. A number of insurance companies that had expected a long-term rate and the long-term spread have found that the short-term rate plus the longterm spread is what they earned. As the spread narrowed over the last year, many of them had absolutely fantastic returns, but they then found themselves unable to continue earning that sort of return. For a while it looked like futures were working magic on their portfolios; now, reality has taken over. Uses for Fixed Income Options

have to give you the full value, so being able to borrow at a fixed rate is essentially owning a put. The insurance company in that case has granted a put. (I would usually say "sold" a put, but there is no explicit fee for the option when it is embedded in an insurance policy.) Could they use the options market to see just what they are giving away? Could we use the options market to see what those puts are worth? The answer is "yes" to both questions. We can buy options to offset those granted in a product. It is possible to combine the option granted with other options to alter the risk profile. And, via options, we can buy or sell volatility without regard to market direction. Figure 2 is an "options" balance sheet put together for an insurance company. There is an asset side and a liability side. The interior of the figure shows the options held by the insurance company and those it has granted. On the asset side the insurance company may hold bonds with puts, or bonds that are extendible, or bonds with warrants. These are all options that they own. Far more important to the insurance company on its asset side are those options they have granted. They may own bonds that are callable. A number of insurance companies holding highcoupon GNMA's are finding out how expensive that option is to their return. The issuer, in a sense, is not GNMA but the individual homeowner who has the right to prepay that mortgage at any time, that is, has the right to call it in.

14 We are going to look at fixed income options somewhat differently. A number of institutions have options in their products. Maybe they didn't realize it, or perhaps for years those options weren't terribly valuable and didn't come back to hurt them very much so they aren't too aware of them. Given the right circumstances, however, these options become very visible. A life insurance policy that says you can borrow at 8 percent is very valuable in this environment. They don't have such terms too often anymore. That right to borrow is a "put": you have the right to give them an 8 percent security and they have to give you "par" for it. They

The liability side is what hurts the insurance companies most. Included are policy loans, cash value surrenders (regardless of what has happened in the market), single premium deferred annuity (SPDA) cash-ins, and guarantees involving the higher of the short or long-term rate. A period rate guarantee occurs where they offer a rate and say, "for any money we take in during the next year we will give you," say, "12 percent." Some of these options are absolutely unhedgable (and the rates offered sometimes appear unattainable). However, they are certainly options that have been granted and maybe the options

Figure 2 The 'Options'Balance Sheet ASSETsmE

Held By Insurance Company

Granted By Insurance Company

0

Putable Bonds

0

Extendible Bonds

0

Bonds With Warrants

0

Floating Rate Preferred At 'Higher-Of Yields

0

LIABILITY SmE 0

Dividend Distribution

Issuer 'Call'

0

Policy Loans

0

Sinking Fund Double-Up Option

0

Cash Value Surrender

0

Mortgage Prepayments

0

'SPDA' Cash-In

0

Implicit 'Put' Option In Forward Commitment Process

0

'Higher-Of Guarantees

0

Period Rate Guarantees

market can be used to alter the risks. In fact, we can buy puts or calls to offset some of them. For example, if we own high coupon GNMA's, we know that the prepayment rate will go way up and our return will be hurt if there is a market rally. By buying calls, we get an offset to this because our calls will become more valuable if the market rallies. Actually, there are several ways of offsetting the option commitments that insurance companies have. The direct offset method is, for example, if you have sold a call, buy a call. Another method is to combine several types of options, as in the following example. An insurance company came to us and said, "We have a mortgage commitment out there for a five-year mortgage at a 14 percent rate." (We'll forget spreads in this example). "At the same time we have guaranteed a fourteen percent rate on a forward GIC We will get the money in three months and we expect the mortgage commitment will be taken down." Looking only at the mortgage commitment, they had a short position in a put. The first assumption would be

that they should buy a put to protect themselves. But after looking at the whole situation, they also had a forward GIC and wanted to have that 14 percent mortgage on the books to generate the income to pay the GIC It turned out that adding a call option was the thing to do in this portfolio. They bought a call option on a five year Treasury, an over-the-counter option. That left them neutral with regard to interest rate risk. If rates rose, the holder of the mortgage commitment would in fact come and borrow the money because alternate sources would be much more expensive. Thus, they would get the money (GIC) and the investment (mortgage) that they needed to pay the cost of the GIC On the other hand, if the rates declined the mortgage borrower could be expected to go elsewhere. After a rate decline, let's say the insurance company can only invest at 12 percent instead of 14 percent. A properly ratioed (structured) position will give enough profit on the call option in a market rally (bringing rates from 14 to 12 percent) to offset the decline in income. So there are ways to combine options that may not be as direct or obvious as others.

15

Other Key Factors Looking now at some other aspects of the subject, there are exchange-traded options on cash bonds, notes and Treasury bills, and options on bond futures. These futures options are the most active options. There are, in addition, options that you can buy from government securities dealers who are willing to take on the risk of being in a short-option position. These options are advantageous in several ways. For example, you could buy an option on a five year Treasury note, something you can't do in the exchange-traded market. You could have it expire three weeks later if you wanted, or a year later, or two years later, and you could set up the strike price to provide whatever kind of insurance you wanted. Specialized options can also be developed. One example we've offered is an option on the yield curve that pays off if the spread between short rates and long rates exceeds a certain amount. This particular option is used to hedge against the kinds of products where the customer has been guaranteed the higher of two different rates. Other examples could be given.

16

To dose, I want to take a look at hedging a short-term liability. Futures contracts are often misunderstood because some academic literature, some brokerage literature, and even some literature coming out of the exchanges themselves have shown examples of perfect hedges lasting for years. In these unfortunate examples, whatever happened in the cash market was exactly mirrored in the futures market, so you could always lock in today's cash rate. That simply isn't so. Looking at an example where a bank is hedging a short-term liability, we will simplistically assume for a minute that we are able to issue right at the Treasury bill rate. Adding a spread to that doesn't affect the analysis at all, except to change our target rate by the amount of the spread. So, we will just forget the spread and say that banks have the right to sell three-month money market certificates and can price them right at the Treasury bill rate. How can they lock in that rate? What is their target rate? How can they do any financial planning?

Let's take a look at the situation on the hedge initiation date when Treasury bills are trading at 8 percent and futures are trading at 10 percent. This is admittedly a very large spread. If we sell the futures contract, we have a liability in the future that we know we are going to have to sell. Money market certificates that are out there today will come due about that time. We want to roll those over, but we want to lock in today the effective rate to the institution on that roll. We sell the futures contract at 10 percent. As time goes on we find that on the futures delivery date - which corresponds to the date we are going to take off the hedge and roll our money market certificate - the Treasury bill rate is 12 percent. The futures rate has to converge to the cash Treasury bill rate here because a day or so before delivery there would be a great arbitrage at that rate if it didn't converge. So futures and cash are both at 12 percent. What has happened? We have to issue our security at 12 percent but we have a 200 basis point profit in our short position. We sold a Treasury bill contract at 10 percent for 90 and it has gone to 88 (12%) the way it is quoted. We made 200 basis points on that trade. So, when we take that 200 basis-point profit away from the cost of our issue at 12 percent, we wind up with an effective rate of return of 10 percent. This corresponds to the rate on the contract when we first shorted it; the effective rate is exactly where we sold the futures contract. If we could always set up our hedges to be taken off on futures delivery days, and if our liability rate were tied directly to bills, we could guarantee that our hedges would be this effective all of the time. Many people would look at hedging effectiveness and say that winding up with an effective rate of 10 percent after an 8 percent rate originally prevailed in the spot market is terrible. In fact, it is determinable beforehand that your target is 10 percent, not 8 percent. The cash rate on the day you sell the contracts has nothing to do with the target rate for that hedge. The corollary would be in the long-term bond case considered earlier. We were not locking in a cash price of 100 22/32 on 12 percent Treasuries. The pricing was, instead, set up to give a short-term rate of return. The arbitrage says this is a fair price. But more importantly, this

kind of situation will result in an effective rate equal to the futures rate. So believe the futures market when it tells you what rate you can lock in, but don't think it's the cash rate. There are three important facts to remember about pricing and hedgable yields. First, futures prices have an

impact on hedges, and the yield curve essentially sets futures prices. Second, very few hedges will appear perfect unless the correct target is used to determine effectiveness. Finally, yield curve pricing constrains most hedges of longterm assets to earning a short-term earnings rate.

17

Options and Futures: Strategic Tools for Portfolio Management (Part II) H. Nicholas Hanson

My presentation will focus on index futures and index options for the equity markets. There are futures contracts on four different indexes and on futures contracts. If you exercise the call option on a futures contract you will receive a long position in the futures contract. There are also options on the underlying indexes themselves. There are also options on industry groups which started to trade this summer. The last two categories, options on indexes and sub-indexes, are all cash settlement options. These are different from options that have been trading for the past ten years on the options exchanges in that if you were to exercise one of the options in either of these categories, you would just receive its intrinsic value. For example, if the index were at 105 and the strike price of the option was 100, a price of five would be received upon exercise of the option.

18

Most of the focus in the field of stock index products is on futures because those have been the bigger markets. To gain a perspective of what's going on in these markets it is interesting to note that the trading volume on the New York Stock Exchange was roughly 45 million shares per day in January 1982. Volume has come down a little bit since the big surge in the late summer of 1982, but has leveled off somewhere around 80 to 85 million shares per day. The volume traded in futures contracts can be re-expressed in millions of shares per day. If, for instance, the S&P index is at 160, the futures contract then is 500 x 160, or $80,000. If you purchase a futures contract on the S&P 500 you're buying an $80,000 portfolio of the S&P 500 stocks. The average price of a share of stock on the New York Stock Exchange is about $40. If you divide $40 into $80,000 you're looking at something like 2000 shares. You can think about a futures contract, then, as being equivalent to 2000 shares at an average price of $40 per share. If you know the number of contracts that are traded every day, go through the same type of arithmetic for each of the four futures

contracts that are traded and add up all those numbers, you can re-express the contracts and convert them into millions of shares per day. Actually, over the last few months the number of shares per day traded in the futures markets has exceeded the number of shares traded per day on the New York Stock Exchange. As we proceed, keep two thoughts in mind. Bob Kopprasch's presentation dealt with the pricing of fixed income futures, and he showed how the pricing was so efficient that you could not receive abnormally large returns by dealing in futures markets rather than in actual Treasury bills or bonds. That's not the case in the equity markets, however. There are times when the futures are quite undervalued, and also quite overvalued, relative to the index itself. If you bought a futures contract on the S&P 500 and it was undervalued, then you essentially would have established a position in the S&P 500 guaranteed to outperform the actual index. The reverse of that argument is that if the futures are overvalued and you sell them, you're creating a cash-like instrument. By "cash-like" I mean a money market type of instrument. It will become more apparent later why this is the case. The rate of return on that instrument will actually exceed the rate of return available in short-term money market instruments.

Who Uses Stock Ind.ex Futures? No one knows, or at least anybody who knows is not telling, exactly how the futures markets break down among their participants. It's our best guess that locals, people who simply trade on the floor of the exchanges, account for about half of the trading volume in stock futures. The next heaviest users would be brokerage firms, block-trading firms, that use futures to hedge the positions they have to go to bed with every night. When buying and selling large blocks of stocks the result each night is a portfolio that won't look like an index but will be diversified. Hedging with

futures is better than not hedging at all. Brokerage firms probably account for about 20 percent of the trading volume. Institutional investors would account for perhaps another 10 percent of volume. They probably represent the fastest growing sector. Then there are individuals who just want to speculate. Futures offer them a way to speculate with leverage that hasn't been available in the history of the markets. Even in the 1920s you couldn't get the kind of leverage that you get here. Individuals probably account for the remaining 20 percent of trading volume. Uses of Stock Index Futures A number of institutional uses for futures are listed in Table 1. First, consider the use in index fund management. Anybody who is trying to run an index fund would naturally wonder if it could be run better with futures. Certainly it sounds like it would be easier.

to essentially reduce transaction costs almost to zero. Separating stock selection from market timing is probably the major opportunity that the futures contract offers to an investor. You can always think about a portfolio of stocks as being divisible into two portfolios. One portfolio would look just like, for example, the S&P 500; the second portfolio would be the difference between the total portfolio and the S&P 500 component. That "difference" portfolio may have long and short positions. If you sold futures against the actively managed portfolio, you'd be neutralizing the S&P 500 portion and just leaving yourself with the difference. The neutral portion of the portfolio, at least theoretically, should return something equivalent to shortterm interest rates. The difference would be alpha. So, a portfolio could be created to return something like shortterm interest rates plus alpha. This couldn't be done prior to the existence of futures.

Table 1 Uses of Stock Index Futures by Institutional Investors .. .. .. ..

Index Fund Management Alter Portfolio Equity Exposure Market Timing Strategies Separate Stock Selection From Market Timing .. Dynamic Portfolio Insurance Programs III> Dividend Capture Programs III> Swapping Portfolios Because these markets are quite large and extremely liquid, futures turn out to be a very easy way to alter quickly the equity exposure of a portfolio. By selling futures against a portfolio you're actually simulating the conversion of some of the stock into cash and its reinvestment at short-term interest rates. There is beginning to be some renewed interest in market timing strategies because the futures market is a very costeffective way to get in and out of the market. Most of the academic work has indicated that this kind of strategy is not profitable after transaction costs, using the actual stocks. Now we have an alternative instrument that allows us

Dynamic portfolio insurance programs attempt to replicate a protective put (i.e., the combination of a long stock position with a long put), by changing the stock-cash mix of the portfolio through time. Since the put is like term insurance against a decline in the underlying stock, this would be purchasing insurance to limit losses due to unfavorable outcomes in the underlying security. Given this strategy, rather than selling stock and going to cash, it would be less costly to sell futures. Futures can also be utilized in dividend capture programs. Corporations are eligible, if they hold stock for 16 days, to exclude 85 percent of dividends received for income tax purposes. In the past, people have done this by buying a stock and selling a call option, a simple buywrite strategy, unwinding the position after the dividend has been paid. One could think about doing this sort of thing with a portfolio of stocks that were going to go ex-dividend by hedging with a short futures position. Finally, futures have uses in swapping portfolios. Suppose you were a plan sponsor who was firing manager A and hiring manager B. One of the problems that you have to face is that manager B

19

will come in, take over manager A's portfolio, then after underperforming the market will tell you, "Well I spent most of the time getting out of manager A's dogs and into my cats." Another problem occurs if the market happens to make a large movement in one direction or another in the first few days after manager B has taken over the portfolio. If B is not fully invested because of the transition, his performance will lag the market's. A viable alternative is to simply sell out manager A's portfolio right away, and let manager B establish a fully invested position in the futures market so he at least has market exposure. Then manager B would have time to decide which stocks he actually wanted to buy. As he purchased those stocks he could sell futures. Salomon Brothers has done a lot of what is called program business. We do this for customers who have a portfolio that they would like to liquidate or swap for another portfolio. The use of stock index futures facilitates these types of activities. Important Contract Characteristics Stock index futures are simply obligations to buy or sell the units of a stock index at a fixed price on a fixed date. There is no problem with early delivery, or any of those sorts of problems that exist in the fixed-income markets. In the equity futures markets there's no delivery at all. They are simply cash settlement transactions. 20

Futures contracts are available on four different indexes: the S&P 500, the New York Stock Exchange Composite, the Value Line Average, and the S&P 100. The size of the contract can always be determined by simply multiplying the index by $500, or by $200 times the index on the smaller S&P contracts. The S&P 500, NYSE Composite, and the S&P 100 are all capitalization-weighted indexes. That is, the stocks are held in the index in proportion to their market capitalization. The Value Line is an equally-weighted index. Price quotes are in increments of .05 (e.g. 160.10, 160.15, 160.20). Contracts expire in March, June, September and December on the third Thursday of the month.

It's important to note that contracts trade 15 minutes past the closing of the New York Stock Exchange. When money supply figures were being announced at 4:10 p.m., this sometimes caused frenzied activity in the futures markets on Fridays, which was always fun to observe. Now the money supply figures aren't released until the futures market closes. Basics of the contract and cash settlement should be noted. Purchasing a futures contract at $100 for a year out implies that at the end of the year you would be able to pay $100 and take delivery of the index, except there is no delivery. In fact, you would receive the difference between the price of the index on that day and $100. Let's look at numerical examples of the cash settlement idea. If you were to purchase a futures contract for $160.10 and the index when the contract actually expired happened to be at $162.20, you would have a gain of $2.10. Multiplying that by 500 identifies a profit of $1,050 ($2.10 x 500). Since the contract expires that day, it is marked to the index close and you would receive $1050 in cash. Variation margin was mentioned earlier. These contracts are settled daily. If we bought a contract at $160, and the next day it closed at $161, there would be a one point credit if you were long, or a one point debit if you were short, which would be settled in cash that day. The reason for this is to preserve the financial integrity of the market. Consider the purchase of a futures contract by an institutional investor. The institutional investor is generally not thinking about leveraging a position. He's not going to take an $800 million position with $30 million in cash; rather, he's going to try to make the same investment in most cases that he would have made in the market anyway. Assume he's going to buy one contract of the S&P 500 index at an index price of 160. The contract size is then $80,000 ($500 x 160). The investor would put up a margin deposit of perhaps $3,000 in T-bills. There would be $77,000 left over, which could be invested in any money market instrument. Tbills might be selected, or perhaps CDs

if the investor wanted to take a little more risk to get a higher return. The net result of the transaction, $80,000, is invested in the short-term money market. At the same time an equity position has been established which has the same capital gain or loss potential it would have had if the $80,000 had been used to buy stocks directly. There are no loans involved even though it's called a margin transaction. The original margin is simply a good faith deposit and interest is earned on this money. Pricing a futures Contract Actually, we an buy futures contracts when we buy stock. When we put in an order to buy 100 shares of stock we don't have to deliver the cash for five business days or a week. That is a forward contract. In seven days you give your cash to your broker and receive your shares. If you could imagine simply extending that period so that the interest involved was significant, then you basically understand the arithmetic of pricing a futures contract. Take a look at Figure 1. Suppose that you buy a stock today for amount S. You agree to sell it to

someone in the future for an amount F. Until you actually deliver the stock to the second party, the stock will be registered in your name and you will be entitled to any dividend this company pays, D. The cash flow you would have is a flow of -S today; a flow of +F in the future at the expiration date of the contract; and the dividend flow of +D. Now, the return to the hedged portfolio (RHP) is: F-S+D. You have created a hedge because you bought stock and sold it forward. Why is it a hedge? Well, look at the terms that appear on the right-hand side of the equation in Figure 1. Each one of those terms is known; you know what you paid for the stock today, you know what you have agreed to sell it for in the future, and you know what the dividend is going to be. If you don't know the dividend exactly, you have a pretty good estimate of what it's going to be. The sum of those terms on the right hand side is always going to be the same. It is not going to depend in any way on the price of the stock when the delivery is made. Since the sum (F - S+ 0) equals the return to the hedged portfolio, the RHP, and is known with certainty, that return should be approximately equal to the return available in the short-term money markets.

Figure 1 Pricing of a futures Contract Hedged Portfolio

Cash Flow

Buy Stock

-S

Sen Forward (Futures)

+F

Receive Dividend

+0

Return to Hedged Portfolio (RHP) RHP=SxRf

F-S+D

Where Rf Is The Risk-Free Rate SxRf= F - S + D

or;

F=S+(SxRf)- D

Futures Price = Cash Price + (Risk-Free Return - Dividend) Futures Price = Cash Price + Cost of Carry

21

If we make a simple algebraic substitution, where the units of the terms are all in dollars, the RHP would have to be the original amount invested in the stock multiplied by the risk-free return, or RHP = S x Rf. Substitution gives: F = S + S x Rf - D. The futures price is simply equal to the cash price plus the cost of carry.

Notice that I've said the "cash price". This can be somewhat confusing. When futures traders talk about the cash market, they're talking about the underlying commodity, or in this case, the underlying index. The terms cash, spot, and index are all synonymous. So the futures' price is equal to the price of a stock, or a stock index, plus the interest rate return you could have earned on your money invested, less the dividend. The same equation can be written in a yield form. Figure 2 indicates this format. The left hand side of the equation is equal to the futures price minus the index price, divided by the index price, multiplied by 100 to put it in percent. This number is called the basis. It should be equal to the difference between the interest rate and the yield on the index. Look again at Figure 2. If you move the yield term over to the left side you get the equation: F-I + Y = R, which looks like the returnIto the hedged portfolio (RHP). These two equations are the same, except one is written in percent, while the other one is written in dollars.

22

Figure 2 Valuation F-I -I-

= R-Y

F = Futures Price I = Index Price R = Risk-Free Rate Y = Dividend Yield F-I -1Return to Hedged Portfolio

R-Y

Figure 3 Return to Hedged Portfolio (RHP) Sell S&P 500 Futures Buy S&P 500 Index RHP = Basis + Dividend Yield Basis = Futures Price - Index Price Index Price Dividend Yield Must be Computed Between Today and Settlement Date of Futures Contract When RHP Is Less Than Your Risk-Free Rate Futures Are Undervalued When RHP Is Greater Than Your RiskFree Rate Futures Are Overvalued

If we were actually talking about the S&P 500 Index we would create this hedge by purchasing stock of each of the 500 companies in just the right proportions. We would have a portfolio that perfectly mirrors the index. If we shorted the right number of futures contracts against that portfolio, we would have created a riskless hedge and the return would be the basis plus the holding-period yield on the 500 stocks, or the return to the hedged portfolio (RHP).

Many times futures in the markets have been over and underpriced. The measure of that overpricing or underpricing is this RHP. Figure 3 shows how we can use the RHP to determine whether futures are over or undervalued. If the RHP is less than short-term interest rates, futures are undervalued; if the RHP is greater than short-term interest rates, futures are overvalued. The advantage of using the RHP is that its calculation does not involve any forecast of what a particular investor's short-term rate is. So, if the short-term rate used for the calculation happens to be Treasury bills and if the RHP is greater than the Treasury bill rate, then futures would be overpriced relative to Tbills. It's more convenient to talk about the RHP because it is a rate that is readily comparable to your short-term rate. Whereas, if we talked about a theoretical futures price you immediately have to determine what interest rate was used to get that number.

Figure 5

Dealing with Dividends

Dividend Distribution for S&P 500

Handling dividend yield in the valuation of futures is more complicated than handling interest in the case of fixedincome futures. With fixed-income instruments the payments are known and they occur with regularity, and the bonds themselves are traded with accrued interest added to the price. Stocks, however, go ex-dividend and there tends to be a reduction in the price when they do so. Except for taxes, that reduction would be exactly the amount of the dividend.

Annualized Dividend Until September Futures Settlement $10.00

8.00

6.00

4-,00

2.00

0.00

100 80 60 40

20

1

8

15

22

29

5

AUG

12

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26

2

8

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29

5

AUG

12

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2

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15

SEP

The price performance of the S&P 500 Index and the December 1983 futures contract on the Index for the period from mid-July until late October 1983 is shown in Figure 6. Notice the range of spreads as well as the average during the period. This spread doesn't reveal anything about whether the futures are overvalued or undervalued since a $3.00 price spread means something different when there is a week left until the contract expires than when there are six weeks or six months left.

Percent of Quarterly Dividend Remaining Until September Futures Settlement

JUL 83

1

"Mispridng"

Dividend Distribution for S&P 500

24

24

JUL 03

Figure 4

17

+..,..-r.....,......,-r--r-,....,.....,....,.....,...,....J, 1i

The dividend yield until the settlement of futures contracts varies in a nonlinear way with time. This is illustrated in Figures 4 and 5, which depict this non-linearity for the 91-day period

9

SEP

ended September IS, 1983, the last day of trading of the S&P 500 September futures contract. From Figure 4, it is apparent that during the first six weeks of the "settlement quarter" stocks that account for only about 25% of the total dollar dividends for the quarter have gone ex-dividend. Thus, the holder of the S&P 500 over the remaining seven weeks will receive about 75% of the quarter's dividends. This makes the effective annual dividend considerably larger, as shown in Figure 5. Since the theoretical basis is equal to the risk-free rate of interest minus the dividend yield, it is possible to have a properly priced futures contract selling at a discount to the index. This will occur if the dividend yield until settlement exceeds the risk-free rate until settlement.

15

Figure 7 shows the RHP, return to the hedge portfolio, versus the Treasury bill rate. These numbers are annualized. Through most of the period - which runs from June 17 up through nearly the end of October - the Treasury bill rate was reasonably flat, drifting down slightly toward the end. Look at the RHP. Figure 7 should suggest that if you were considering buying the S&P 500 around the first week of September, you'd be much better off buying futures. If you do that, you are picking up a spread of more than 2 percent. Essentially this is the amount by which you're going to outperform the S&P 500 by buying the futures. It's an annualized number, so it may look bigger than it actually is. This spread is called the futures buyer's alpha. Figure 8 does not contain annualized data and gives a more useful appraisal of what's going on. Around August I, the spread was about 1 percent. This 1% is not an annualized number; it is 1%

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Figure 6 S&P 500 Futures Contracts DECEMBER '83 VS. INDEX Daily Data - 6/17/83 to 10/21183

176

Sell Stock Index Futures Instead of Selling Stocks

December '83 Futures Contract

174172 170 168 166 164 Buy Stock Index Futures Instead of Buying Stocks

162 160

158 +-.,.........,~"I"'"-r--...,.-""f"'-.,....."""""/-...,..-.,....-r--"I"'"-,......,.-""f"'-.,....."""""/-..,

3.0 2.5 2.0

S&P 500 Index)

Spread (Futures -

3.5

!\:: ~:/\~. ;:\ !

~/'~:..!\".

.r./1\.. J-......

.

1.5

0\.:: 0. •.

:.. /0.

19

26

\/ ~...1:. ~.•".'•.:

Average Spread

.

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.

1.0

17

24

1 8 Jul '83

15

22

29

5 12 Aug

2

9 Sep

16

23

30

7 14 Oct

21

Figure 7 RHP of S&P 500 December '83 Futures Contract Vs. December 15 Treasury Bill Yield. 6/17/83 to 10/21183

Daily Data -

13

Annualized Yield (%)

Sell Stock Index Futures Instead of Selling Stocks

12 11 10

24

T-Bill Rate

....................!

...........................-

_ .

.

9 8 7

A

RHP (Return to the Hedged Portfolio)

6 4.0

Spread (%)

2.0

......................./ /

Futures Buyer's ALPHA (Annualized)

\ \

/ ../

:.

/.t\/·· \ /

\ .. ........

0 -2.0 -4.0 Spread (T-Bill -

-6.0 17

24

1 8 Jul '83

15

22

29

5 12 Aug

19

26

2

9 Sep

16

23

30

RHP)

7 14 Oct

21

Figure 8 RHP of S&P 500 December '83 Fu tures Contract Vs. December 15 Treasury Bill Yield 5

Yield to Set (%) .... .............

Daily Data -

'~'

...............

U nannualized

.........

4

6/17/83 to 10/21/83

...........

••...•.•••••...•...•.....

T-Bil! Rate

........!

3

.

..........

A

2

RHP (Return to the Hedged Portfolio) I-

Buy Futures

Spread (%)

24

1 8 Jul '83

15

22

29

5 Aug

12

for the holding period. You would have outperformed the S&P 500 if you had bought the futures, took the $80,000 ($500 x 160) that is the equivalent value of the contract, put it in Treasury bills and used them as collateral, or as a good faith deposit to purchase the futures. The degree of better return was 1%. The figures you see don't indicate what the S&P 500 was selling for on a given date. If, for instance, it was 160 and you were buying it at a 1% discount, then you are buying it at 158.40. That means that no matter what happens you know you're going to outperform the S&P by $1.40 over the next three months. There is actually a non-zero standard deviation about the $1.40 due to the effect of the daily mark-to-the-market. If your contract happened to go down initially, you would not have the full $80,000 invested in Treasury bills because you would have to liquidate some of them to meet the daily variation margin. The standard deviation is small, however, and can actually be hedged away to a large degree. This "mispricing," when these markets first started to trade, was quite large. In

19

26

2

9

Sep

16

23

30

7 14 Oct

21

the early summer of 1982, for example, there were mispricings of $6.00 to $7.00 on the contracts. If you bought futures instead of the S&P 500 you were buying the Index at a discount of about $7.00 from its actual price level. So, if the Index last summer was $110 you were buying at at $103. Mispricings that large have disappeared, but significant ones still remain. Why do they exist at all? I think they exist and are going to continue to exist for two reasons. The first is that the underlying instrument for these contracts is not something that's easy to deal with. There is no single bond, bill, or ounce of gold that can be delivered to satisfy the contract. The underlying instrument is 500 different stocks. It becomes unwieldy to deal in that large a portfolio. You might think of constructing a portfolio of 20 to 30 stocks that looks something like the S&P 500 and is fairly well diversified. This can be done, but then you've got some tracking error. Your homemade index is not going to track the S&P 500 perfectly. Hence, there will not be a perfect match and mispricing will occur from time to time.

25

The other reason is the up-tick rule. For example, suppose the market is going down and futures are very cheap. You say, "111 just buy futures and short my little 20 stock portfolio." You may not be able to get off your short positions because of the up-tick rule. Once you've established the position, even if you can get it established at a favorable spread, when the contracts expire you can't deliver the portfolio even if it's all 500 stocks. You've got to liquidate it and then deliver cash, because the contracts are settled in cash. So, there can be large transaction costs involved with the underlying instrument.

26

For these reasons, excursions around what we think should be the "fair value" in an academic sense will exist. While they may be difficult to arbitrage away for a pure arbitrageur, they present opportunities that institutional investors can take advantage of. Suppose you are beginning to get a little bit nervous about the stock market. You have some nice gains, but the market has been up all this year, and you think you ought to take some profits. In the past, the way you did that was to sell some stocks and invest the proceeds in Treasury bills or something like that. If, however, futures are selling so that their RHP, or implied short-term interest rate, is significantly above the Treasury bill rate, you can just sell futures contracts against your portfolio. You are hedging only the market portion, but presumably that's what you want to hedge. At the same time, you are investing that cash at a rate that is higher than the rate available from the money markets. The transaction costs for doing this are essentially zero compared to the cost of getting out of your stocks, especially if they happen to small-capitalization companies be where your selling might have a large impact on the price.

ment contract you are going to deliver in cash the difference between the price of the index at the expiration and the price at which the contract was originally struck. In the case of an option, you have the right to make or accept the delivery, but you don't actually have to do it. For that reason, the theoretical price of an option cannot be computed entirely on a cost of carry basis the way that the futures price is computed. This is because the option price contains an insurance premium. I think the most helpful way to think about options is in terms of insurance. A put option is analogous to an insurance policy. You buy a house and take out insurance on it. If it burns down, you receive a payment. You really bought a "put" on that house. So, an index put is simply insurance on your portfolio. Option valuations depend on many of the factors that futures valuations do. Both the futures price and the option price will depend on the time left until the instrument expires, the price of the underlying index, dividends until expiration, and interest rates. The crucial difference is that the option price depends upon the volatility of the underlying instrument whereas the futures contract price does not. With options you're buying or selling volatility. Futures simply involve delayed payment. Figure 9 shows the familiar return pa ttern of a long call option. Superimposed is a probability distribution of what the Figure 9 Return Pattern of Long Can Option Return ($)

.... Probability

Futures vs. Options The distinction between a futures contract and an option contract essentially is that the futures contract is an obligation. With an option, you either act or don't act, as you choose. When you purchase or sell a futures contract, however, you have obliged yourself to deliver something to the other side on the expiration date. If it is a cash settle-

Stock Price

o I"----=,.......,,~----""""- at Expiration

stock price might be at expiration of the option. If you were to purchase a call option struck at some price, you would then have the right - but not the obliga-

Han - to purchase the stock at a fixed price through exercise. If the stock is above the strike price you simply exercise the option, get the stock, and sell it to make the difference. The advantage of the option is that you have a limited loss. The most that can be lost is the premium paid for the option. You've given up some of the upside, but not a lot. If the stock goes way up, the option goes up too. The nice thing is that you have the downside protection. Although the pattern shown is that of the return pattern of a long call option, exactly the same pattern exists if you happen to be long a stock and long a put. This is why this is referred to as insurance. The way that we can think about valuing an option, at least intuitively, is to take each possible return, multiply it by the probability of that return occurring, and add up all those numbers. You would then come up with a fair price for the option. The outcome depends on volatility, as illustrated in Figure 9. By increasing the range of possible stock prices at expiration (i.e., by increasing the width of the curve), you increase the value of the option.

expensive, because that would have been insuring each of the individual stocks. Therefore the insurance would have cost much more than insurance on the whole portfolio, which is really what you want anyway. I think the easiest way to see that insurance on individual stocks would cost more is to imagine that you have a portfolio that goes up - except for one stock that goes down. If you had puts - that is, insurance - on each of the stocks, you would collect something on that one stock that went down. If you had a put on the whole portfolio you would not collect anything, because the portfolio went up. For that reason, puts on individual stocks are going to cost more on average than puts on the whole portfolio. This, then, is very nice way to insure a portfolio. It's very convenient to create the same type of instrument by simply putting all your money in Treasury bills and using the income from the bills to buy index calls (long money market, long calls). You then have another insured portfolio. In this case the portfolio could be one that is actively managed.

~arketlnsurance

There are dynamic strategies that can be used to insure a portfolio by shifting back and forth between stocks and cash. The same kind of return pattern can be created, perhaps more easily, by simply holding a portfolio of stocks and buying puts on a particular index. The most actively traded puts are those on the S&P 100. The S&P 100 Index behaves pretty much like the S&P 500 Index. It deviates a little bit, but it's not going to deviate wildly. You could take a portfolio of stocks, buy S&P 100 puts and essentially insure that portfolio against market risk. Prior to having index-traded options, the only way you could have done this, other than using some kind of dynamic replication strategy, would have been to go out and buy puts on all the individual stocks. It may well have been that the puts didn't exist, and if they did exist that they would have been prohibitively

One benefit of portfolio insurance is that you know in advance what the cost of insuring your downside risk is going to be. Second, you still have significant upside potential, underperforming the market in up or flat markets only by the cost of the insurance. Third, the cost of insurance per unit of time is known with certainty, which is not the case in the dynamic strategies. A final benefit arises because of strike price difference: you can create a deductible policy. If an index is valued at 100, and you purchased a put struck at 90 rather than 100, your put struck at 90 would be cheaper because the index would have to go down more before that put could payoff. That's exactly analogous to buying a deductible insurance policy. Together, these varied index futures opportunities offer many benefits to portfolio managers, not only for aggressive purposes but also for risk control and portfolio characteristic modification.

27

Using Options and Futures In Managing Pension Portfolios (Part I) Sumner Abramson, CFA There are many good reasons for using options and futures, and many different methods of using the various kinds of options and futures vehicles that are currently available. There is also a bit of controversy. Each portfolio manager will have his or her own ideas about how these vehicles should be used, if at all. They are known as "derivative vehicles" because they are not "real" securities in the conventional sense - they are derived from the "real" securities. Don't let that fool you - they are very real in what they can accomplish.

Useful Tools

28

It is important to understand at the outset that these derivative vehicles are investment tools to achieve some objective. Options can be described as insurance for which you pay a premium. Futures are an excellent hedging mechanism, an indexing tool, a cheaper way to index and hedge. They are an efficient, fast, and inexpensive tool for accomplishing specific objectives, and for getting into or out of the market very quickly. To buy a list of stocks, a trader will start working from the offering side. To sell a list of stocks, a trader will start working from the bid side. That spread can be an eighth of a point or more. It's expensive to move in and out of stocks. The $.05 or $.10 we pay is really the transaction cost, not necessarily the commission. Futures allow us to trade more efficiently and cheaply. Last week, the Boston Globe carried an article that discussed the decision by Harvard Management Co. to index $300 million of its portfolio with futures. They are liquid and it is easy to do. The danger is that using futures may be so efficient and so easy to do that it will cause portfolio managers to mess up their accounts. But be that as it may, if a good tool is there, and is the right thing to use, it should be employed. Futures can be considered as a pure hedge. An option, however, has different characteristics. One of them is its use as insurance. Futures can simply be

used to index a portfolio to the S&P 500 or, as some institutions are doing, to try to earn an incremental return to the index return. Futures trade at premiums and discounts, although not by as much today as they did when they were a new investment vehicle. The futures market is an auction market; you can get an increment to the index return if you buy when futures are trading at a discount or sell when they are trading at a premium. Futures are a good markettiming device. Options, on the other hand, are a way to transfer risk from the seller to the buyer of the contract. This ability to transfer risk obviously can help the portfolio manager achieve some objective, either as just another arrow in the quiver or in managing a dedicated program. APPUCAnONS Option Income Funds An example of using options not related to pension management is the option income fund. I was the first portfolio manager of the first option income fund. When the first option income fund was started, the objective was to get a high dividend return which could be paid out to shareholders. The alternative, of course, was bonds. This goes back to 1977 when you could get 8 percent on a pretty good bond. In an effort to achieve a higher return than the bond yield, mutual funds were started that had the objective of high current yield. At that time they were getting a 10 to 12 percent return. These returns were achieved by buying stocks and writing options on the stocks. The objective was really to set up a better income fund. Buy-Write Programs The area of buy-write programs is very competitive right now. One of the sectors that is growing fastest involves dividend capture programs. These are not strictly pension products, but corporate products. Corporations that receive dividends from other corporations can deduct 85 percent of the total from their

taxable income. In effect, the 46 percent corporate tax rate is taken down to 6.9 percent. However, corporate treasurers certainly are going to be loathe to invest in stocks. They've been hurt in the past by investing in straight preferred stock programs; what they found was that when interest rates go up, preferred stocks go down. One way to increase returns but maintain downside protection is to buy high yielding common stocks and simultaneously write in-the-money options. This is essentially a buy-write program, but it is an in-the-money buy-write program. Two-thirds of the l'harket risk can be removed by the in-the-money features. This is a great tool. Corporations need a place to get a higher aftertax money market return than a Treasury bill which, while guaranteeing principal, only yields 4 to 4.5 percent after taxes. This is an example of hands-on portfolio management in the options area. Due to the risk transference capabilities, a lot of money will be put into straight buywrite programs in the future, especially if the bond market picks up again. Another possibility is to work out a good method for buying stocks and selling options on those stocks to achieve specific risk-reward relationships. This is like setting up a bond substitute program, and such programs are in fact being set up today. A basic goal of a buy-write program is to outperform the S&P 500 by a percent or two per year, with only about twothirds the "index" volatility. Of course, you can read books that tell you this is a zero Sum game and it can't be done. Nevertheless, it is being done today, largely because of the availability of this new tool. Overwriting A new program utilizing options came into being six or seven years ago called overwriting. It is a very interesting concept, but it is possible to get killed in a sharply rising market. However, over the years we've gone through a learning curve and have developed methods offering some protection against getting caught. There's just one objective to overwriting: earning an incremental

return. The guts of this program is not unlike stock lending, which does nothing more than put to use an asset that is sitting in a bank vault. If you have common stocks sitting in a bank vault, you can earn money by lending that stock. Overwriting does essentially the same thing. Basically, a pension fund administrator might hire an overwrite options manager to sell options on an equity portfolio managed by somebody else. The general stipulation is that the options cannot be exercised; tha t is, stocks can't be called away from that other equity manager. One attraction is that the pension fund administrator doesn't have to allocate any assets to this, at least not during the formative stages. That could happen later on if things go awry. There are several systems referred to as dynamic option overwriting that really work. However, there are dangers to these programs. If you sell options on a portfolio that is going up and you cannot allow those stocks to be called away, then when an option gets exercised you have to buy in the stock. This occurs, obviously, at a higher price. Your only alternative, if you're in danger of an option being exercised, is to buy back that option at a higher price, at a loss. Option writing can deliver an incremental return of a percent or two a year, if it is done carefully and systematically. That amount can be viewed by the plan administrator as paying our fees. 90/10 Programs Another kind of program has taken on the name "90/10". This means that ninety percent of assets are placed in Treasury bills, or other money market instruments, while the other ten percent is used to buy calls or puts, depending on whether you are bullish or bearish. Or, that ten percent can be used to buy individual stock options or puts, depending on your ability to call individual stocks moves. The rationale for this kind of program is valid. If we do our jobs right as portfolio managers and the market goes up, we make a lot of money. On the other hand, if we don't do very well on our

29

stock selection, or if we call the wrong direction of the market, we don't lose any money. The interest earned on the ninety percent presumably will cover losses in the call/put portion of the portfolio. It works. Conclusions These are all examples of what are called "dedicated" programs. An objective is determined and a program of options, futures or combinations is established (dedicated) to meet that objective. I'm sure that when some portfolio managers with relatively large cash positions decided in August 1982 to change their minds and become more fully invested, they did so easily by buying futures in the market. That was also a dedicated program. Another would be the use of an option consisting of several stocks in an industry. For example, if you wanted to get energy exposure but you really didn't know just which stocks to buy, you could buy energy options. This would give you a position and also give you time to work into the stocks you really wanted to own. That is almost insurance, but perhaps in a reverse sense.

30

The easiest way to understand the insurance that relates to options is to think of yourself high at the top of a wonderful market rise. For one reason or another you don't want to sell your stocks, but you think the market is going to go down. Obviously, buying put options is going to help. Buying the option has an advantage over selling the futures: if you're wrong about the direction of the market and it keeps on running up, you are going to lose your insurance policy (the puts), but you will still have your portfolio working for you. That's a different type of hedging vehicle than futures. In the future, we are going to see more industry options, like the several technology options now available. I believe there will be tremendous growth in all of these derivative instruments. Remember, however, that they are derivative instruments. The single most important part of any program is really the underlying security, even when that underlying security is cash. Everything else just changes the characteristics of the underlying securities, either individually or as portfolios. They are tools for management enhancement.

Using Options and Futures In Managing Pension Portfolios (Part II) Robert E. Shultz Paul H. Fullum MAJOR FACTORS IN THE 80'S The comments today are focused on futures and options from the pension plan sponsor's viewpoint and are, incidentally, non-excathedra to the IBM pension fund. The focus will be on the conceptual uses of the new ,and burgeoning markets and will not attempt to address such things as perfect hedges and basis risk. Too often, investment discussions end up as seedlings in the forest rather than the forest itself. We will leave it to the investment professionals to debate these issues. The following are some views on stock index futures from a private study of money managers conducted in September of 1982. Although the study focused on stock futures, the issues are at the root of the use of derivative instruments in a broader context. One common view was that: Stock index futures have generated interest among portfolio managers, but few institutions are incorporating them into money management procedures. The reasons stated were: Appeal is limited to speculation and market timing; Little pressure from clients, and competitors; Expectations that stock index futures will not spread like options. From the same study, some comments from the less enthusiastic: It's just another toy . . . no appeal, even to large investors.

and the greatest rewards are in risks. Perceptions have changed greatly in the short time span of a year. The point is, the survey was addressed to the wrong audience. Plan sponsor uses of futures and options will prove to be the largest, single new tool in the 1980's having major impact on how we address our funds' investment objectives. To date, much of the discussion has continued to focus on uses by investment managers in specific portfolios. This is not the issue. The question is not whether IBM's investment managers should use financial futures, stock index futures, or options. 1£ they feel that these markets enhance their ability to execute strategies, that's their call. The basic issue is the value of the manager's investment insights. 1£ the fixed income manager's interest rate judgements are wrong, or the equity manager's market sector and issue selection is not well founded, the use of futures and options is not going to turn the bad insights into good decisions. First, let us define the major issues. They are: Options and futures will be a major factor in pension fund strategies in the 1980's. Pension sponsors in general, and managers in particular, are a long way from efficient structuring and understanding of "multiple manager" portfolios. Options and futures are not a stand-alone investment strategy - they are integral to investment policy and strategy.

Our clients aren't sophisticated enough to understand, even if I do.

Their use assists in proper performance attribution.

I think it's a hedge against risk,

Options and futures should en-

31

hance "active management."

Efficient use of multiple managers - Control of market risk - Cyclical patterns/hedge manager's portfolio - Create optimal portfolio: non-market risk vs. expected return

They offer potential for uses vastly greater at the sponsor level. Their uses are neither a pure hedge nor speculation, but are risk/bias/completion management. Next, we will summarize some of the specific uses of options and futures in support of the preceding statements on the impact of the markets on plan sponsors. These uses include:

The conclusion will focus on our experience using stock futures in a restructuringmode. EFFICIENT MULTIPLE MANAGER STRUCTURES

The ordering closely reflects those that are most readily executed to those that focus more at the basic policy issues. Other uses tend to cover the areas of greatest impact on a longer-term basis. They include:

Most multiple-managed portfolios do not reflect the intent or expectations of the plan sponsor. The primary reason is that the efficient trade-off between risk and return has not been dealt with effectively. The role of multiple managers was originally a means of diversification in the face of growing cash flows. Since passive strategies currently offer a more efficient means of diversification, most recognize that the role of the manager should be purely and simply that of obtaining superior returns. The potential deficiencies of the multiple manager structure, not surprisingly, are ones that can be addressed in part by futures/options instruments. They include:

Risk control - Hedge unwanted risk exposures to factors and sectors - Implement factor and sector biases - Completion holdings

Dissipation of best decisions Overdiversification at high fees Lack of risk control "Closet" indexing Growth creates need for many managers

Arbitrage-Cash/Futures Market Asset Allocation and Timing Cash Management Index Funds Dynamic Hedging Restructuring and Trading Programs Anticipating Corporate Cash Flows

32 Table 1 Typical Multiple Manager Portfolio Risk Profile Annual Standard Deviation of Market Annual Standard Deviation Non-Market Risk Total Portfolio Risk Level

20.13 3.26 20.40"

Analysis of Non-Market Risk Industry/Economic Factors Stock Selection .. Standard Deviations Not Additive

82% 18%

Manager's business risk overrules investment risk These observations are nothing new. What is new, however, is the potential of the futures/options markets to effectively address them. Table 1 shows why it is unreasonable to expect most multiple-managed funds to generate returns in excess of the market indexes. Although the total fund exposure to non-market risk should be minimized, the individual portfolio exposure must rationally be greater to take advantage of the ability to diversify away non-market risk, while retaining the incremental return potential.

individual stock only marginally affect the shape of the plan sponsor's distribution of expected returns, index options can result in major changes to the risk/return density function. Figure 2 shows a normal distribution function for an efficiently constructed plan sponsor portfolio. The expected return for this portfolio is 4%, after adjusting for the effects of inflation. The risk assumed to achieve this level of return is reflected by the standard deviation of 14%. Figure 2 Options Plan Sponsor Usage

Figure 1 illustrates that a required alpha of .38 basis points is certainly far below FREQUENCY most sponsor's expectations for their 0.03 ~---------------, managers. OPTIONS - USE BY PLAN SPONSORS Most of the uses of options and futures focus on futures instruments.

0.02

The critical issue facing a plan sponsor is the risk and return potential of the aggregate portfolio. Options on individual stocks is an issue for the investment manager and how he implements his investment insights. Options on broad market indexes are a plan sponsor issue. While options on an

0.01

0.00

Figure 1 Required Alpha

MEAN RETURN STANDARD DEVIATION

REQUIRED RETURN

6.38% 6.0% 1=-=-=-""'-=-""'-=--==-=-""'-=--=o;;'Ir

20.0%

-4-r"'l"'l"l;::;:;"TTTTn..,..,....,.,.TTTTT'l..,..,....,.,.TTTTT'l""""'"""

- 50 - 40 - 30 - 20 - 10 0 10 RETURN

20.6%

RISK (S.D.)

S&P 500 MEAN RETURN 6% STANDARD DEVIATION 20% = 400 UNITS VARIANCE 400 • 6 = 66.7 FOR 1% RETURN 66.7 UNITS VARIANCE

MANAGED PORTFOLIO RESIDUAL STANDARD DEVIATION 5% = 25 UNITS VARIANCE 25 • 22.7 = .38%

20

30

40

4.0% 14.0%

Figure 3 is a concept which was originally presented by Walter Good, vice president of pensions at the Continental Group, Inc. The concept is to overlay a utility curve on the density function of expected returns. No attempt is made to plot the precise utility curve; the shape of the utility function is the important concept. If the pension fund's portfolio should return the expected 4% return, the plan sponsor should be indifferent and neither happy nor unhappy with the results.

50

33

Figure 3

Options Plan Sponsor Usage 0.03-.----'---------------,

0.02

ASSIST IN PROPER PERFORMANCE ATTRIBUTION

0.01

0.00 --n'TT'mT"MrTTTTT,..,..,...".,'I""I"i:::n-TTTT"MrTTTTT-n::i'!"I -50 50

UTILITY CURVE

34

portfolio. The density function is shifted to the right by the amount equal to the premium income achieved as a result of writing the options. The second change to the density function is that the righthand tail is truncated at the aggregate strike price for the options. It is clear that the plan sponsor who invested in the optioned portfolio would have a better utility relationship with his portfolio for the specific time period represented by the risk/reward relationship.

As we move toward the right-hand portion of the distribution, the utility of the plan sponsor's results is always increasing. The important concept is that the marginal rate of change in utility is decreasing as the returns of the pension fund increase. The reason the utility curve has this particular attribute is that it is easy to put money into a pension plan, but very difficult to get money out. Contributions can only be reduced to zero. In addition, it should be expected that when the results of the investment portfolio are very good, there will be pressure for higher benefits by the beneficiaries, and some of the gain may not be retained by the corporation.

The important uses of futures/options are not in a stand-alone mode. Quasiarbitrage of cash and futures makes sense as long as opportunities are present, but one should not stop without getting to the heart of basic policy and strategy issues. In their 10th anniversary issue, Pension and Investment Age asked for comments on the biggest surprise of the decade. Harold Arbit, President of TreynorArbit, made one of the most thoughtful comments, stating in part that he felt the biggest surprise was, "the continued lack of sophistication in interpreting past performance data." Comparing managers' returns to the S&P 500 to assess skill level is a fruitless exercise. Figure 4

Options Plan Sponsor Usage

0.03-,------------------, /

It is also interesting to plot the utility

curve as our results become negative. As we move from the 4% level of expected return down into the negative numbers, our satisfaction with the investment results certainly decreases. With each incremental move down the return axis, our marginal utility falls at an increasing rate. At some point, we reach the point where the actual survival of the sponsoring firm is brought into jeopardy by the poor performance of the pension fund. Figure 4 indicates what happens to our density function when a plan sponsor writes call options on his entire

I

I I I

0.02

I I

I PREMICM I INCOME I I

I

0.01

I

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,

\ \

\ \ \ \ \ \

\ \ \ \

\ \ \ \ \

/

" 0.00 --n'TT'i"Fi'mrTTTTTT"M..-n:'I""I"i:::n-TTTT"Mn-rTTT..,J;::i"I-l -50 50

UTILITY CURVE

We sponsors spend large amounts of time on this effort when 98% of the return is determined by the market and exposures unintended by the manager. Futures and options markets offer the potential for hedging away the market and the unintended exposures and tracking the manager's alpha. Quarterly review meetings would certainly be more useful if the focus was on the 2% of the return where the skill is evidenced. I would hasten to add that the futures and options markets are academically not needed to accomplish this objective. Proper performance benchmarks or normal portfolios would accomplish the objectives.

ENHANCE ACTIVE MANAGEMENT An extension of the prior thought - an added message - would be to use options and futures to enhance active management. For a number of years, many sponsors have been urging their managers to be more aggressive and to take more residual risk. This effort has largely been a failure, not because of investment risk issues, but for extremely rational business risk considerations. If a manager is to be measured against a broad market index, it is irrational to expect him to take risk. Added risk carries with it increased volatility. Downside volatility leads to getting fired. Under careful scrutiny, we would likely find the plan sponsor at the root of "closet index" strategies to the extent they exist.

RISK/BIAS/COMPLETION MANAGEMENT

apply both to stocks and bonds, but the S&P 500 cash/futures swap has generated the most interest. Incremental returns of 500 basis points have been attained ~ff ~ ~~ 12 m~~. I wooW caution, however, against extrapolating these results. The difficulty of efficiently trading a cash market proxy, and the tendency for demand to come forth from hedgers first as the markets develop, may be inefficiencies of the past. The strategy is, however, essentially riskless and should be utilized even for net increments of 50 basis points or less.

Asset Allocation/Timing This is no doubt the most obvious use, and one that I will spend little time discussing. The opportunities and flexibility accruing to sponsors is a major one. Full use in asset allocation and timing will allow plan sponsors to gain control of the fund's asset mix independent of, and non-disruptive to, the investment managers. The ability to execute in size is an important corollary.

Cash Management Cash is not merely a residual in most sponsor's funds, but is and should be treated as an asset category. To the extent that the cash component does not reflect the sponsor's intent, a stock or bond "STIF" fund can be created. Considering the working cash or friction cash held by each manager, the aggregate cash position is many times in excess of pure strategy cash and, therefore, should be in long assets. 35

Index Funds An issue which has stirred some controversy is the attempt to draw a distinction between pure hedging or speculation and the use of the markets by sponsors. Some experts feel that the point lacks merit. However, the specific uses that follow support this point. The first set of uses are those of a specific nature and of interest, even though not directly impacting basic policy and strategy issues.

Quasi-Arbitrage Cash/Futures The

applications

of

quasi-arbitrage

Use of futures and cash is an attractive alternative to a traditional index fund. This is particularly true for an offshore investor wishing to invest in a U.S. index fund. The use of futures results in less currency risk, at least relative to the dollar.

Dynamic Hedging The use of futures as the cash market vehicle for constructing the hedge is appealing, primarily due to the savings in transaction costs and the lack of disruption of the manager's portfolio strategy.

Anticipate Corporate Cash Flow Many pension funds receive their contributions from the sponsor corporation on a quarterly basis. Table 2 indicates the unintended results of having a quarterly cash flow to the plan. In this example, we have one pension fund receiving a monthly contribution and the second pension fund receiving a quarterly contribution. The net contribution for both pension funds during the quarter is zero: benefit payments exactly equal the gross contribution from the plan sponsor. Both indicate that the time-weighted rates of return for the two pension funds would be identical. However, the actuary is only concerned with the dollar-weighted rate of return, and in our example, the dollar-weighted rate of return is significantly different. The table was constructed to dramatize the point that corporations that receive

their contribution on a quarterly basis have higher risk than corporations that receive their contributions on a monthly basis. It would be a fairly simple procedure to offset the quarterly contribution schedule through the use of financial futures. RISK CONTROL

The use of options and futures in risk control includes: - Hedging unwanted risk exposures to factors and sectors. - Implementing factor and sector biases. - Completion holdings. The first two uses are the flip side of one another. Let's use small stocks or the size issue as an example. If a fund has a number of small stock managers believed to have insight over and above simply being in the sector, the total

Table 2 Anticipate Corporate Cash Flow Monthly Contribution

36

Month

Beginning Market Value

1 2 3

$100 75 56

T.W.R.

Performance

-25% -25 +78

Market Net Value Contribution

$ 75 56 100

$

Ending Market Value

0 0 0

$ 75 56 100

$-10 -10 +20

$ 65 39 89

0% Quartedy Contribution

1 2 3 T.W.R.

$100 65 39

-25% -25 +78

$ 75 49 69

0%

Monthly Contribution T.W.R. Dollar Weighted Return Not Equal Adds Unintended Risk

Quarterly Contribution T.W.R.

Figure 5

stock participation can be increased by going long the NYSE futures contract and simultaneously shorting the S&P 500 contract. Numerous other examples can be identified in this area.

Systematic Risk Management 900 800 700 (3 600 500 ~ 400 .-- 300

3 200 100

II1II SPECIFIC SYSTEMATIC lIB HEDGED

o

LUL

o

UNHEDGED

Completion holdings refers to establishing or increasing a sector not covered by the fund managers. Energy and technology contracts are examples currently available - although probably the biggest void in most funds is a substantial underweighting in electric utilities.

HEDGED

EFFICIENT USE OF MULTIPLE MANAGERS

COLONIAL ADVISORY SERVICES, INC.

The use of futures in the efficient use of multiple managers includes:

fund may be overexposed. Selling contracts constructed to hedge out returns from small cap stocks will achieve fund objectives while retaining the manager's alpha contribution. Conversely, small

- Control of market risk. - Cyclical patterns/hedge manager's portfolio.

Figure 6 Equity Program 1.06

1.05

l

1.04

1.03

I

%

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.......

I

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RETURN 1.02

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1.01

37

,,

,

1.00

-----,,

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,.--_1

0.99

JUNE

4

8

9

10

13

14

15

16

17

20

120 100 80 SALES

60 40 20 0

PORTFOLIO S + P 500

21

22

Create optimal portfolio: nonmarket risk vs. expected return. The ability to control systematic risk is probably the most powerful use in terms of the plan sponsors, as illustrated in Figure 5. To the extent that market risk can be reduced through selling contracts against a portfolio, the greater the total portfolio will reflect an efficient trade-off between risk and return. One also has the ability to control cyclical patterns by hedging the managers' portfolios. For example, we have a small-cap, high-tech portfolio that is managed internally. The portfolio manager might come and say, "I don't want my portfolio for the next three months. Can I put it to you?"

If we thought that was the proper thing to do, we could hedge his portfolio return out of our total fund. Two or three months from now, he might become positive on the new issues market and small-cap stocks again and come back and say, "I want it back." We would then take off the hedge. Powerful flexibility exists without being disruptive to the investment managers.

The final aspect of efficient use of multiple managers is in the creation of optimal portfolios. We've talked about this one in terms of non-market risk versus expected return. The issue here is that you can construct a hedge to the extent that you're buying the manager's alpha. You can construct things so that you're dealing with a risk/return trade-off between the non-market risk and the return attributes. It's a variation on the

Figure 7 Equity Program 1.06

1.04

% RETURN

1.02

1.00

38

0.98

JUNE

6

8

9

10

13

14

15

16

17

20

250

SALES

200

PORTFOLIO

150

S + P 500

100 50 0

21

22

same theme. Effective Portfolio Liquidation We have initiated one substantial trade where one portion was done through the traditional guaranteed/incentive while another utilized futures. Figure 6 represents the portfolio liquidated by using the futures market coupled with an orderly liquidation. The portfolio tracked the S&P 500 very closely. We put the hedge on where you see the bottom bar and then told the manager to work off the trades slowly. The hedge ratio was kept fairly even through that period. We think this is an extremely effective way to liquidate portfolios.

Figure 7 shows the alternative. This portfolio also tracked the market within 50 or 60 basis points daily. No doubt the result of a long list of confluent events, on the day of the incentive trade the portfolio dropped 150 basis points below the S&P 500. No further comment is necessary.

SUMMARY In summary, we ask you to think of the powerful uses of these new tools from the plan sponsor's perspective and submit that the substantive uses are plan sponsor issues. These are new tools that address all of the old problems that have been with plan sponsors for years.

39

Modifying Portfolio Characteristics Using Options Lloyd McAdams, CFA By way of background, I have been actively involved in the stock options market since 1973, when the Chicago Board Options Exchange (CBOE) started in a room that was about the size of a hotel suite. Call options on thirty stocks were traded, all of which expired on the last day of the month during only four months of the year. Times have changed rather dramatically since then. The options business is now much more elaborate and the futures business has evolved into a popular method of hedging. One thing, however, has not changed at all, and that is the aspect of being an options manager that I find to be the most difficult - explaining how to use options and why these strategies succeed or fail!

risk/return curve without having to invest in cash. The first and foremost strategy used to modify a portfolio's return characteristics with options is to write covered calls at-the-money. Figure 1 graphically illustrates this strategy. Figure 1 Covered Can at the Money

....... Any discussion of options management - ------- --- - --can be as convoluted as one would like .' it to be. We can discuss elaborate math ------,I!-----------:i'--------formulas or butterfly spreads, or we can talk about the idiosyncrasies of executing horizontal and vertical rolls. These ..... concepts are indeed important if options .. ' are to be managed effectively, but their inherent complexity makes them relatively ineffective when explaining to a client how this or that options strategy can reduce or expand a portfolio's risk/reward characteristics. ---:;~-----------

40

I will focus my remarks on how I attempt to resolve this communications dilemma and how I respond to clients when they ask, "Why are you doing this?" Covered Cans At-The-Money Remember how you adjusted the risk/return characteristics of your portfolio before the advent of the options market? For those who took the CFA exam when I did, the study material focused on the theory of efficient frontier. Risk/return relationships were adjusted by using cash. Now, however, adjusting risk/return relationships and the asset allocation process can often best be achieved by using new hedging strategies. There are now ways of moving up and down the

The 45-degree diagonal line equates the return from the underlying stock with the return from the option "strategy." If the underlying stock and the stock and option strategy provided the same rate of return, the point would be on the dotted line. The horizontal dashed line on the chart represents the short-term, risk-free interest rate. This rate and how it relates to the option strategy is by far the most important concept to keep in mind when explaining how to modify risk with options, since risk modification with options only occurs in a relatively short-term time horizon. The heavy line is the return from the option strategy.

The most significant weakness in the covered call at-the-money strategy is its lack of material risk reduction during periods of significant market weakness. The return produced after there has been significant depreciation in the underlying stock is almost directly proportional to any further decline in the underlying stock. The strategy, therefore, has its greatest appeal when portfolios require a rate of return significantly in excess of the risk-free rate over the full market cycle, and interim period negative rates of return can be tolerated. Covered Calls In-The-Money Another basic strategy is the covered call in-the-money strategy depicted in Figure 2. Notice the difference from Figure 1. With thi:- strategy it is possible to make a positive rate of return above the risk-free rate for a wider spectrum of poten tial stock prices. Figure 2 Covered Call in the Money

.. .' .,'

----- - -- - --- - - - - ------

---- ;~----- - --- - - - ------

..' ..

....

'

........

....

is used as a substitute for an investment in fixed-income securities. The basic appeal is that the in-the-money call strategy has a high probability of producing returns above the risk-free interest rate. This incremental return historically has been greater than that from long-term bonds and short-term, fixed-income securities. Let's compare Figures 1 and 2. The potential expected return from the atthe-money call is, of course, higher than from the in-the-money call. The farther you go in-the-money, the closer you will be to the risk-free rate of return. Therefore, an option contract should never be sold when the expected return, if the stock is called away, is below the risk-free rate. Long Stock, Long Put Options Strategy The long stock, long put strategy depicted in Figure 3 is a fairly recent development since puts became more available in 1977. It took such a long time for the put market to develop because of the SEC's moratorium on new listings. This long stock, long put strategy provides the investor with an opportunity to make substantial positive returns when the underlying stock appreciates, and provides a fixed maximum loss no matter how much the stock might decline. This appreciation potential is, however, always less than the return from the underlying stock. The difference in return is the cost of the put option. This cost is analogous to the purchase of insurance protection against any large loss.

.......

.............

One negative aspect of the put strategy for taxable investors is the reduced ability to earn a long-term capital gain on the stock on which the put has been purchased. The IRS has, in the past, ruled that put options on stocks created a situation where the investor was not sufficiently at risk" to receive the favorable long-term capital gains tax treatment. U

In-the-money option strategies are used primarily by investors who are very risk averse and cannot, during interim periods, accommodate material declines in stock prices. Frequently, this strategy

For an insurance company or for an individual investor, there is considerable value if the strategy creates a long-term capital gain. All option strategies for these investors, therefore, should be viewed on an after-tax basis, because

41

calls by creating a put from a call very easily through these synthetic puts, and vice versa. So, a long stock, long put position is similar to holding cash and buying a call. The same risk/return characteristics will be present.

Figure 3 Long Stock Long Put

.....

-----------------------

-.~~.7·-----

------------

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.'

.'

the returns will vary with the tax treatment.

The one thing that's particularly important is that this is the only strategy that has an absolute downside maximum loss. This is not possible with futures. Unfortunately, this loss number is rather high. It might be a maximum of 5 percent absolute loss. So, the question for managers who handle insurancetype portfolios or manage money for taxable corporations to ask is, "Is there a way to limit the loss and have even a lower loss risk?" Sure there is - one could shift the striking price of the put. But the more interesting approach is a covered-call, long-put, split-strike-price strategy. This is the strategy for these investors. Depicted in Figure 4 is the long-stock, long-put, with a covered-call at-the-money strategy. Something very important has happened. In Figure 4, the left side of the solid line has edged its way up to Figure 4

Put/Can Strategies Some interesting option strategies that have recently become quite popular are those that combine the concepts of puts and calls.

42

Covered Call Long Put Split Strike Price

Some investors are using the "90/10 strategy" - 90 percent cash, 10 percent long calls. The investment results from this strategy are very similar to the buy stock-buy put strategy. Hence the "90-10" is also the basis of a synthetic put. As a point of interest, this strategy has not been very popular among investors. This is a good example of an option truism: "puts and calls are just the same, except they're upside down." Many of you remember the options market when there was only an overthe-counter market in calls, puts, and straddles. They used to advertise them in the Wall Street Journal as come-ons in the mid-1960s and early-1970s. When you sell somebody a straddle, you can create for yourself either a put or a call. You can also create two puts or two

.......

..,

.......

.'

.'

.'

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....

zero. In fact, the basic parameter when executing this trade is to get this line a little above zero. Hence, the result is a transaction which, at all future levels of stock price, genera tes a positive return. The only other transaction that I know of that has that characteristic would involve Treasury bills or commercial paper. In any event, there is now another way of creating short-term rates of return: covered-call, long-put, split-strike price. For those of you who like to have numbers to work with, 111 use an IBM option example. Just as a matter of trivia, IBM is the one stock, in my opinion, where the basic market may not be made in New York, but in Chicago, on the CBOE. Many people think that New York just follows what goes on in Chicago. Those of you who have ever stood in the IBM crowd in Chicago, even as early as 1973, will know that there has always been a lot of action there, particularly before the split. When you look at the volume, and there's no question that the volume in IBM options has a tremendous amount of capital at risk, there might be strong reasons to believe there may be more capital at risk in Chicago on IBM common stock than there is in New York. No one knows for sure. Now, back to the IBM option example. The stock is at $121 and we are now in mid-December 1983. Let's talk about April puts and calls and split the striking prices to $120 and $130. I am long in stock, sell a 130 call and buy a 120 put. I want to be able to sell my stock at $130 if it goes up, and I want to be sure of an out at $120 if it goes down. The stock is slightly out of the money. The premiums should be the same. Both the put and call now sell for $5. The net cost should be $121, plus five and minus five. And if we're lucky, at this level the put will actually trade for less than the call. So, if you go to April, you will hold IBM for 120 days or so and will then get a dividend. As I remember, the annual dividend is around $4.00 a share. With the dividend, your cost is $121 and you get a dividend of $1.00, so the worst thing that happens is that you get $121($120 + $1) back in April. The best

thing that happens is that the stock goes to $130. You have nine points on the stock plus a $1.00 dividend, or a total of ten points. You have earned a fourmonth return of 8-1/4 percent (10/121). Three times that amount gives an annual rate of return of about 25 percent. You have taken an interesting stock which you may like and created a boundary of rates of return of 0 to 25 percent annualized. If you are right about the stock's attractiveness, you get an annualized return of 25%. If you're wrong on the stock, you get zero. This is a nonlinear, risk-return adjustment, and this is the key that separates options strategies from futures strategies: the pattern of returns from options is non-linear. One might want to make the strike prices the same. When the option strike prices are the same for IBM, the" return curve" looks like Figure 5 - a straight line. There is no way to buy stock and buy a put when the stock sells at $120 and make anything other than the figureS Covered Call Long Put Same Strike Price

.... ....

... .....

.......

....

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..,

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43

short-term interest rate. If anybody implies that anything other than that can be made, you are being misled.

rolls. They aren't essential. The key is knowing where the stock will be on the expiration date. That is what it's all about.

Getting Involved With Options I've been in the options business for ten years now, handling rather large portfolios. The business of working with pension funds, however, has been rather disappointing. I've done a lot of missionary work, explaining to pension fund managers how options can work for them. I've learned that most money managers really don't seem to want to get involved. The net effect is that it hasn't been a great business in the sense of generating fee revenue for the money managers. It would have been great for the pension funds, and a few of them have used options with quite a bit of sophistication and success. The business that has evolved from out of this, a business that is really very attractive, is working with taxable money. For a pension fund, a risk-free rate is always available to them - gross. Whether they get the return in capital gains, dividends or interest, there is no tax bite.

44

For a taxable corporation, the risk-free rate is not the same in all three circumstances. Interest is fully taxable. For a corporation to earn the risk-free rate using options strategies, collecting all the income in the form of dividends is appealing, but also extraordinarily difficult. Hence, the biggest product challenge that is now out there for options managers is the dividend capture process, which is a very elaborate one. The IRS regulations are very, very specific and consistent. If you are a very good manager, you might not only be able to satisfy the IRS requirements, but also might even collect a premium if your stock selection capability is particularly good. The basic problem of options managers is that a lot of people think that options themselves do something for you in advance. The only thing that options do is allow you to work in a non-linear fashion. The one important point to remember is: The best options managers are those who know where the stock will be on the expiration date. Forget the butterfly spreads. Forget how to do the horizontal

Many of you are security analysts or have security analysts that work with you. There is only one thing you really want to know: what is the probability of IBM being below $110 on April 15, the expiration date? The security analyst may want to talk about earnings, about upside potential, or some other piece of IBM esoterica. You can just say, ''I've got one bit of risk here. Tell me it's not important." If the security analyst will come forward and say, "There's no way, zero probability, it will be below $110," you have just identified a way to sell that knowledge and make a rate of return above the risk-free rate. You need to be aware of the IRS policy on being "at risk." The strike price can be no more than 20 percent in the money. If it's more than 20 percent in the money, the tax status with the IRS has changed. You are not considered to be "at risk", even though a lot of money can be lost from this "not at risk" position. Different Stocks - Different Strategies Now let's try putting all these strategies together. How do you manage the money? How do you adjust the risk and return of the portfolio? There is no single strategy that works for every stock. Every different stock characteristic requires a different strategy. Is the market outlook positive or negative? What is the option premium level? Figure 6 shows a matrix of appropriate strategies depending upon option premium levels and the outlook for the market. When the market outlook is positive and premium levels are high, the best possible strategy in this situation is to own the stock. Do not get yourself in a box and panic because options cannot be used all of the time. It's perfectly okay just to own the underlying security! If, however, option premiums are relatively low - that is, option premium levels relative to short-term interest rates are low - buying calls makes a lot of sense. If you don't like the market, you can hold cash, or sell calls deep in the money. If premiums are low and

a boss, or it is not executed the way they heard it described, there is a problem.

Figure 6 ... Positive

H;"[

Buy Stock

OPTION PREMIUM LEVEL

~j

MARKET OUTLOOK

Negative ...

Sell Calls Hold Cash Combination

Of Strategies

Buy Calls

Buy Puts

you don't like the market, you can buy puts, particularly for pension funds where there are no taxes. There are, of course, combinations of strategies. The way to look at this problem is to iden tify ten sectors of the market believed to be almost unique and independent from each other. The market outlooks and the premium levels for each sector can be put on a chart like Figure 6. Hence, you will find that sometimes there will be stocks on the put side in our portfolios, plus stocks where there is no active option strategy, plus some on which we're buying calls. All decisions depend on the premium level and market outlook in those individual sectors. This is the essence of modifying the risk/return characteristics of a portfolio. The real challenge is to find a format in which it will not only be executed, but will also show what has been done in a visual manner that makes clear the gains and the losses arising when the strategy is modified this way or that way. A security analyst has an outlook for every stock, and if by identifying some knowledge about what this stock will or won't do, you have an opportunity to zero in on something that can be quantified. When the security analyst says, "While you're in this stock, it won't go down much. It may not go up much, but it can't go down much," you have something with which to work. For those of you who have been trading options most of your professional life, this whole discussion has been rather elementary. But, it's in the explanation of the option strategy that most managers fall apart with their clients. If it is explained improperly either to a client or

I recently became involved with starting a financial futures fund, a public limited-partnership fund. We trade financial futures on all kinds of things, mostly currency and bonds. One of the people who is actively involved in the fund's activities, and to whom I had made a presentation, saw me in the elevator one day. He said, "How's your foreign currency money market fund doing?" I looked up and said, "Foreign currency money market fund?" I had talked to him for 30 minutes about buying futures, and told him that while I didn't think there was a lot of risk, he could still lose some money. He thought I was managing a money market fund. He had heard what I said in a completely different way. Fortunately, he tipped me off that he hadn't heard what I said. Your clients don't know as much as you think they do about the nuances of options. It's critically important in client relations to actively explain what has happened. All too often, people think, "They're going to do something beautiful for me; they will make 3 percent extra return right out of the sky." It's not that way at aU because such results only come to the options manager who already knows where a stock will be on the expiration date.

:If-:If-

*:If-

Question: Do you use the selling of put options with any of your clients? 45

Mr. McAdams: Put options are generally considered speculative by definition by practically every state or securities commission in the United States. So, if you are buying a put option, you do so with a little risk. If you sell a put option, most state or securities commissions in the United States will not support your action. They see it as highly speculative activity which they will not approve. Even if you disagree with this interpretation, you run a serious risk, in a fiduciary capacity, if you go against this view. Question: If Congress changes the tax law and reduces the capital gains holding period back to six months, do you

expect the price of options, premium, to go up noticeably?

the

Mr. McAdams: Any investment where it becomes possible to capture a longterm capital gain should, by definition, go up since its utility is greater. It's a law of economics. You should evaluate all potential returns on an after-tax basis. Because many of the managers in this business are trading on an after-tax basis, you should be also, even though your client doesn't pay taxes. Question: How do you account for what appears to be very mediocre investment performance by option mutual funds? Mr. McAdams: The objectives of option income funds are very specific: to provide a rate of return greater than that for short-term investments or bond investments, with more stability. However, brokers have sold the concept as if these were stock funds seeking only appreciation. When the market went up 30%, option income funds were up only 18%. Since 8% was the target, many options managers thought they had done just fine. It's the investors, expecting their portfolio to be up 30%, who thought they had done poorly. Question: Do mutual funds use covered call writing as a strategy?

46

Mr. McAdams: Yes, but they use it selectively. They may only sell calls when they don't like the market outlook. Also, they have been using calls the way futures can be used - as a great way to raise cash. Question: Are you saying that there is a place for covered calls? Mr. McAdams: Originally, before modern option developments, funds had policies against option writing that were written in blood. They just could not conceive of owning a stock that they had to write a call against. Now, however, funds are getting smarter; everybody has learned what not to do, and learned something about what can be done. Hopefully, benefit will come from that. Question: Is there any need to determine the theoretical value of an option?

Mr. McAdams: When you speak to the people who run the arbitrage desks at brokerage firms, you find they are very interested in the theoretical value of options. But you have to consider what you are trying to do as a money manager. Let's take the futures example, because I think it's the same question whether it relates to futures or options. Assume the stock market is going down, and the only way to get 50 percent in cash fast enough is to sell futures contracts. Someone comes up saying, "All the futures are under-valued today, don't sell them." The only thing I know is, if you sell a futures contract that is undervalued, and the market goes down 25 percent, you have protected yourself against 22% of the 25%. You have given up 3 percent for being so foolish as to have sold when futures contracts were undervalued. When you decide where the market is going - that is, when you decide where the stock will be on expiration date - that is the most important decision you make. You then sell whatever is best to be sold, theoretical value not withstanding. Question: Are there any implications, in your view, from the recent suit of a company seeking to prevent its stock from being used for options contracts? Mr. McAdams: I would say if you as a company didn't want that extra liquidity and think that the extra liquidity is detrimental, you should have a right to keep your stock from being used. The New York Stock Exchange would not list that stock without your permission. In fact, they won't list it unless you pay them a fee; you have to really want it. In the options markets, they take your stock out of the blue today and say, "We're using you." You should have a right to decide where your option trades. If you think that it's detrimental, you should be allowed to withdraw it. Dr. Murray: I would like to add a note on that. I believe it was Homestake Mining that asked that their stock not be used for option contracts. There were long discussions, they were ready to sue and then it got settled. It seems to me that you could demonstrate that the option market was not detrimental to corporate capital raising.

Mr. McAdams: In 1973, there were 30 stocks on the CBOE. A broker's Autex would make it known that they would buy or sell 5,000 shares of any CBOE stock at the last sale price. To my knowledge, that was the first time that the actual benefit of being listed on the CBOE was manifested. Anyone could buy or sell at that price. That was the first time it was perceived that extra liquidity resulted from the options market. And I think most corporations would perceive extra liquidity as being a desirable thing. Dr. Murray: Just one other comment on the subject of pricing. We have valuation models that are carefully designed and have been thoroughly tested. Their output, however, is not necessarily the final answer. If I want to go short a major stock and am worried because I am a fiduciary and everybody's told me

about unlimited loss, I just want to buy that out-of-the-money call instead. 111 have limited my loss. What is the value of that call to me? It's not necessarily the value of the same call to Lloyd in one of his particular programs. He might be right on a value different than mine, but 111 buy those calls all day long because they permit me to make a short sale that otherwise would be out of the question for me as a fiduciary. So, there will always be different people working on different strategies under different circumstances with different defined objectives. That's why we have such an active market. While pricing models are designed to give some kind of an equilibrium price, you shouldn't be surprised when actual prices are different than that equilibrium price. There are very good reasons.

47

Using Futures and Options on Futures in Managing Fixed Income Portfolios Pa tricia A. Owens

I am going to talk about some of the practical aspects of using futures and the business conditions that lead to decisions to use them in portfolio management. I will do that by taking a case study approach, focusing on three different futures applications with which I personally have been involved. The first two cases I'm going to cover have a commonality in that we took a core portfolio approach in making our decisions. I think you11 understand that better as I talk about the business risks we were looking at and how we approached solving them. Assuring a Minimum Return The first case involved a very small pension fund located in Buffalo, New York. Their problem was two-fold. First of all, their pension fund was in trouble. It was losing money and was going to selfdestruct. Second, the company didn't want to make further contributions to the plan because they wanted to take that money and use it to expand their business. They worked with their actuaries and came to the conclusion that if the pension fund could earn 10% a year for three years, they would be able to take that approach. 48

It sounds easy enough, but how do you guarantee a 10%-per-year return for three years? The solution ultimately used was one where the assets were allocated 80% to fixed income and 20% to equities. For the fixed income portion, we decided to use hedging strategies. This involved using financial futures to protect against market value changes. That assured a minimum rate of return on a portion of the portfolio. Knowing what the return on that part would be with a fair amount of certainty, more risk could be taken in the equity portion. So, that 20% of the portfolio was very aggressively managed.

The really interesting part of this story was that there were two people at the

company who were responsible for deciding to adopt the strategy and for administering the plan. They were told by their boss that if it didn't work, they wouldn't be getting their bonuses. So, their personal bogey was also 10% a year. Management wouldn't have to make contributions, and these two people would get their bonuses. It was a very practical problem from the point of view of the chief financial officer. The result from use of the strategy was that the original three-year cumulative 37% compound return goal was achieved in 18 months. The fixed income portion was definitely doing its part. The equity portion which was very aggressively run, was up over 100% in one year. Not only was the company able to stop contributions after 18 months, but they were also able to adjust the risk of the total portfolio, shifting from 80% fixed/20% equity to 50/50. In addition, they were able to improve the benefits without having to make any further contributions to the plan. This clearly was a strategy that worked effectively for the company from a business point of view, not just from the portfolio point of view. Providing a Secondary Liquidity Pool The second case involved a medical insurer, one of the more aggressive in the country as evidenced by the fact that they own stocks. Most medical insurers don't hold equities. This company sought to provide a sort of layered set of assets, available for meeting underwriting claims, yet facilitating their aggressive orientation. They reasoned that they could achieve this goal by establishing several pools of liquidity, each pool having a greater degree of risk. The first pool they looked at was a high liquidity pool, basically limited to investments of six months or less, and very much like a money market fund. It was the pool that they expected to access to meet the ongoing medical

claim expense. The second pool was a backup. They didn't really expect to have to tap this pool, but if they did it would be on short notice. Its investments were long-term bonds. One risk they didn't want to take here was a lot of market risk, so they engaged in hedging. Specifically, they used a socalled short hedge where you buy bonds and sell futures contracts against the resulting bond portfolio. Hedging of that secondary pool limited the market risk. If the world were perfect, they would have been left with just the income on the long-term bonds as their return. Of course, that isn't what you earn. You earn a short-term rate. Because this was a period when short-term rates were higher than long-term rates, they were able to earn more than the risk-free rate. Their third pool was an aggressively run active bond fund. The fourth pool was a stock fund. The theory behind this structure was that their liquidity needs were met by pools one and two. Because there was a degree of certainty on that large portion of the total portfolio, they could take a lot more market risk with the remainder. The results of the strategy were quite similar to those of the first case, with one major difference. When they implemented this plan, they didn't fund it with cash. Instead, it was funded with a bond portfolio which was underwater. To take those bonds and immediately hedge them would have put the company in an awkward situation from a business perspective. While they wouldn't have had any further market risk, neither would they have had any opportunity to recover the losses. To implement a fully hedged strategy immediately didn't make any sense. The strategy to start this program was, first of all, to eliminate everything in the portfolio that was not very hedgeable to minimize the basis risk. Second, the holdings in the portfolio that were quite hedgeable, like the Treasuries that were directly deliverable into the contract, were immediately hedged 100%. Then with what was left (about half of the portfolio), we did a little timing. We would wait for the market to move up and if it did, we would either sell the bonds with the new gains or else hedge

them at that time. We also established a floor. If some of the market went down to a certain point, we hedged the securities involved regardless, because we didn't want to make things any worse than they already were. The result was that after three months, we were able to structure a portfolio that could be easily hedged. Once it was properly structured, the results were very similar to the returns achieved in the first case. Protecting a Rate Guarantee Regulation in New York State has not allowed an insurance company's general account to use futures or options; this will change in March 1984. There are a couple of things we contemplate doing then which I think would be appropriate to discuss. The most obvious application for hedges seemed to me when I went to Equitable to be in the GIC area. This was a product I never conceived an insurance company could write because it seemed so risky. Now that I am getting involved at the tail-end of that business, I see that I was right. It is a very risky business, and one difficult to handle. One of the big problems with a GIC is that you guarantee a rate to the client, but you don't get the money when you quote that rate. So, you're at risk during the elapsed time between the two events. If interest rates go down before you get the money, you are not going to be able to find an investment that will produce the income stream to match the liability that you've created. This is a situation that clearly calls for a legitimate long hedge - an anticipatory hedge. Most of the obvious hedging applications for futures tend to be on the short side. The GIC is one that is not. Basically, as soon as you know how much money is coming in, you're going to buy enough futures to protect against a market change. This would offset any change in the interest rate obtainable when you actually were able to buy your permanent investment. Protecting a Forward Commitment A second application for an insurance company involves a forward commitment process. For example, insurance

49

companies often want to own direct placement securities, private placements of certain lower quality, typically Baa. They're not always easy to find, and w hen you do find them and make the commitment, it's usually some time before a deal is actually closed. The risk that the company is exposed to is a rise in interest rates during the time between commitment and the closing. You can't park that money under your mattress - you must do something with it; but if interest rates go up before you actually close on your deal, or even find a deal, you're not going to have all the dollars you started with. If that happens, you will have to go somewhere else to get the money to invest so that you match your liability stream.

50

You can do two things to alleviate this problem. You can, again, take a long call or a futures position to protect yourself over the appropriate time period, or you can make a temporary investment in a cash instrument, for instance a Treasury bond. But because you don't know when your permanent investment is going to close, you may well end up with a temporary investment whose maturity extends beyond the closing date and that you may have to sell at a loss in order to pay for your permanent investment. Now, selling at a loss can be a problem. Either you're going to have to borrow the money to make up the difference, which certainly implies a cost, or you're going to have to take the money from some other liability, which is going to undermine the asset base for that liability in the future. Ideally, if you make the temporary investment, you can hedge its value by selling futures against it, or by buying a put. However, under current law in New York State, we cannot buy puts. All we can do now is write calls against the temporary investment. In the end, if rates do rise and you have to sell the security at a loss, the loss will be offset by the gain in the futures or option position. Being 100% hedged is not always the right business decision. This strategy eliminates your possible opportunity to make money on the upside, not just meet a liability. It is appropriate to consider being somewhere in between 100% hedged and 0% hedged. You may want to eliminate some of your risks, but not necessarily all of them. It's a

judgment call. Basis Risk and Convergence From a theoretical point of view, each of these approaches sounds like something that should be done. But, they're not all that straightforward there are catches. The first thing to remember about a hedge, especially in the futures market, is that you don't totally eliminate risk from a portfolio when you hedge it. You really substitute risk. You get rid of market risk but you substitute basis risk. Basis is the price difference between the cash market instrument and the futures market instrument that you're using. It's just a subtraction one minus the other is the basis. Look at Figure 1. The top line represents the cash market, the bottom line represents the futures market, and the shaded area in between represents the basis. If you plot the difference between spot and futures prices, you get the basis line at the bottom of Figure 1. Now, if you compare the basis line on the bottom to the spot line to the top, you can see that there is a substantial reduction in risk. But the fact that the line is wiggling means you still have some risk left. Figure 1 Basis Basis is the Difference Between the Spot Price and the Futures Price Spot - Futures Price = Basis /100 - 99.50

=

.50

P R I

C E

TIME

The key to understanding and efficiently managing a hedge is to understand

what affects basis. Look at Figure 2. If the correlation between the instrument being hedged and the instrument used to hedge it was perfect, the basis chart would resemble the chart at the top of Figure 2. We have a straight line, or constant basis. I've never seen a basis chart that looks like that. For example, bond contract correlation over time is very high: almost 99%, if not higher. But that remaining 1% does leave some room for error. Thus, the second chart in Figure 2 looks more like a normal basis. Figure 3 shows the determination of the futures price. One factor that affects basis is the shape of the yield curve. And the shape of the yield curve dictates the shape of the futures price curve. Figure 3 shows a very simple example of how that works. Let's assume that you have a positive yield curve with short rates at 10% and the long rate at 12%. Your carry cost, the difference between those two, would be 2% annually. For 90 days, or per quarter, this works out to 1/2 of 1 percent. Now, to figure out what the futures price is going to be, let's assume the bond price is 100. If we subtract the carry of 1/2 of 1 percent for 90 days from the stock price, we will get a futures price of 99 1/2. In a negative yield curve environment, it works the other way around. If you have a 14% short rate and a 12% long rate, your futures price is still going to be the spot minus the carry, but in this case the carry is negative, so it's going to make your futures price higher. And the price curve in the futures will be upward sloping as opposed to downward sloping in the positive yield curve case. Figure 2 Basis Risk Basis Risk is the Risk that Basis does not Stay Constant Over the Life of a Hedge Constant Basis

~ ~!---------------TIME

Normal Basis

_------

~~...

TIME

Figure 3 Determining the Fu ture Price Positive Yield Curve Short Rate Long Rate Carry

10% 12 % + 2.0% Annual + 0.5 % Quarterly

Spot - Carry

12/83

~

Futures Price

3/84

TIME

Negative Yield Curve Short Rate Long Rate Carry

14 % 12 % - 2.0% Annual - 0.5 % Quarterly Spot - Carry = Futures Price

1100 + 0.5 = 100.51

TIME

What does that mean? We need to pause and look at the concept of convergence. Take a look at Figure 4. At delivery, whatever the underlying commodity is, the spot price of that commodity and the futures price have to become the same. Therefore, before delivery, the futures price is the spot price minus the carry; at delivery, the futures price is the spot price. The relevance of the yield curve can be visualized from Figure 3. Assume that you were on the positive yield curve. The futures price curve is downward sloping at the point marked 1983. If nothing else changes and you have a futures position, that futures contract price will have to go up. And it will go up. The futures contract price is going to go up relative to the cash price, and this means you're going to have a basis loss. On the negative yield curve, things work the other way. Convergence will be to your benefit and will improve your return. Dynamics of Hedge Management Theoretically, what you are really getting in the hedge position is a short-term rate. In real life the futures price is

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Figure 4

Concept of Convergence Before Delivery: Spot - Carry

=

Futures Price

1100 - 0.5 = 99.5

At Delivery: Spot

=

Futures Price

1100

=

100

I

If Nothing Else Changes, the Futures Price will Move to the Cash Price

Implications

52

Futures Position

Shape of Yield Curve

on Return

Long Long Short Short

Positive Negative Positive Negative

Increase Decrease Decrease Increase

---

Impact

seldom exactly at the short-term rate. One of the reasons for this is the "wild-card" option. Briefly, the wildcard option refers to the fact that when the contract expires, the futures market closes at 3:00 p.m., while the cash market closes at 5:00 p.m. and you don't have to tell the exchange until 8:00 p.m. what cash market instrument you're going to deliver. So if something happens between 3 and 5 p.m., you may have some choices on what instrument you are going to deliver. It might be that news came out that forced the cash market lower or made another issue cheaper than one that was cheapest at 3:00 p.m. The contract price reflects that delivery option. The cash market brokers determine the value of the wild-card option - they price it. So, rather than seeing convergence at the spot price, it's only going to go to spot less the price of the wild-card option. There are ways that you can make such factors less difficult to deal with. One thing is to try to focus on convergence. There is an easy way to eliminate its total impact since convergence is mostly going to take place in the last few weeks prior to the contract expiration date. For example, don't establish your hedge position entirely in the nearby contract, which might be March. Instead, start

out in the nearby, then gradually roll into the second nearby contract before the convergence can really hit you. In stead of having a three-month instrument, which a fully hedged longterm bond would be, that is slowly becoming a two-month, one-month, two-week instrument, you always have a three-month instrument. Also, keep in mind that the same way of determining the appropriate hedge ratio is not going to work in aU environments: sometimes it has to be dynamic. In a negative yield curve environment you want to have as many contracts on as you can because convergence is going to work in your favor. If you use a factorweighted hedge, which is the simple one, you won't be hurt too much. A duration-weighted hedge, which produces a larger number of contracts, should be used in a negative yield curve environment. But, don't use this same type of hedge when you see a positive yield curve. You've got to use dynamic hedging ratios in a positive yield curve because of convergence. Another thing to keep in mind is the correlation between the cash and futures markets. Over time, correlation is very high in the deliverable bond against the bond contract - maybe 99.5 percent. But in the short run, it can be much lower than that. So, rather than design your hedge ratios based on a long-term correlation figure, base them on a short-term correlation figure. Look at what long- and short-term correlations have been doing in the recent past - 30, 60, or 90 days - and adjust your hedge ratios accordingly. In some environments, certain kinds of ratios don't work. For example, in a negative yield curve environment you would want to take the position that would give you the most benefit from correlation so that convergence works in your favor. Do use a factor-weighted hedge in this circumstance since it will give you more contracts, and that's what you want. But, in a positive yield curve environment, you can't rely on that. So you want to use a strategy that would lighten the impact of the convergence. Here's where the rollover on a timely basis - the dynamic ratio - comes into play. It can be a lot more effective at times w hen, on the surface, hedging looks like an expensive way to accomplish something.

Hedging is not always the right thing to do, but there are degrees of hedging. Sometimes being fully hedged is the right thing. Sometimes not being hedged at all is correct. The right approach changes over time. Hedging isn't something that should be rejected out of hand as being either expensive or inefficient. Nor should it be dismissed because the risks are not fully understandable. Hedging can and does make a difference in portfolio performance. To the extent that a portfolio has an impact on your business, hedging can make an impact on the business. ****

Question: Concerning the accounts you are permitted to hedge, can you hedge a separate account? Ms. Owens: Yes. The insurance company law concerning separate accounts in New York, which I believe also affects several other states, passed and became effective as of September 19, 1983. On that date, separate account management could get involved in futures. From the perspective of the general account, the regulation has yet to be written but must be completed by March 19, 1984. I don't expect to see it completed one day before that. Until that time the general account will not be using futures. Question: Can non-insurance companies also structure a GIC in the manner you described? Ms. Owens: I don't know why anyone besides an insurance company would want to structure a GIe. From the perspective of a GIC, you don't really need to protect the value of the asset because they're not being marked to market. Instead, the key risk is that your income stream won't match your liability stream. Hedging is important to the extent you are at risk for certain periods of time when you don't have the money - or when you have it, but you don't have a permanent investment for it. Question: Do you have any rules of thumb that you use about when to be fully hedged, when not to be, and when to be SO/50? Ms. Owens: I must tell you that my views have changed with my

associations. In the first two cases, I talked about being an investment advisor. We were very conservative because that was the role we were supposed to be playing, and we tended to be fully hedged most of the time. We did have a certain amount of flexibility to go as low as a 50% hedge, but over a four-year period we only used that authority four times. Now, my attitude is different because my objectives are different. I'm looking at a real business problem which has to do with insurance products and the investment strategies that result from those products. I don't think it makes sense to be too conservative because you're eliminating all your opportunity for gain. I don't think that's a good business decision. So I'm infinitely less conservative than I was before. It's dictated by the objectives for doing what you're doing. Question: For example? Ms. Owens: If, in the case of the GIC, I were to eliminate all the possible risk of rising interest rates, I'd feel great. The risk that I'm hedging against when I'm waiting for that money to come in is that interest rates go lower. But if I fully hedge against the risk, I would have no opportunity to reinvest in a bond that will produce a higher income stream, and thereby increase my profits. Question: So, is it your interest rate forecast that determines the degree to which you hedge? Ms. Owens: That certainly is going to have something to do with it. Question: When would a company like Equitable use options as opposed to futures in hedging their GIC or some other risk? Ms. Owens: I don't think I can give a really concrete answer, but I'd say you can basically do the same thing with options as you can with futures. It becomes, I think, a question of price. There are times when futures hedging is expensive. I think it's been expensive lately. If you weren't using a dynamic kind of hedging ratio, hedging in the futures market has been very expensive in the past 18 months or so. You were

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probably much better off using options to accomplish the same thing. Question: Could you be a little more specific on the contracts you used in the case situations you cited? Ms. Owens: Sure. You have to remember we were back in 1979 in the first case and that our return objective was 10% at a time when the only thing that had a 10% yield on it was a Ginnie Mae. That's what we started out with, and we probably spent two years using the Ginnie Mae contracts. That contract was much more efficient then than it is now - who knows what it's relating to today. We started out with the Ginnie Mae 9 1/2 contracts. As interest rates went higher, we sold the 9 1/2s and bought lIs. Interest rates kept going up. We sold the lIs and bought 12 1/2s. Then we sold the 12 1/2s and bought ISs. We were able to roll up and keep the current yield on our portfolio very high. Question: Did you change your number of contracts as the coupons moved up?

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Ms. Owens: Yes, definitely. We had to have a weighted hedge. When your contract has a coupon of 8% on it and you have a security with 15% coupons, the ratio of those two instruments is so different. You want to try to match duration to the extent that you can. You've got to increase the number of contracts as you go into a higher coupon. But we could take some risk if we were quite certain that interest rates were going to change directions. We went from a 100% hedge position to a 50% position three times between 1979 and 1982 and were able to capture some market return as well as the short-term rate for the hedged portfolio. Of course, varying

the hedge percentage also increases the risk. You can be wrong. But in this case our objectives were clearly spelled out; we knew exactly what our role was for this fund and how much risk we could take. If the market rallied for two weeks and we had had a 50% hedge, we probably would have at least been reprimanded - the client was not looking for us to capture two-week market moves. However, we were expected to capture significant market changes and were able to do some market timing. Question: You said the Ginnie Maes were more homogeneous when you started and lost that homogeneity with the passage of time. Why did this occur? Ms. Owens: Well, I think part of the reason is that the players and the futures were not as sophisticated as they are today. They tended to track the current coupon, and since interest rates were going up, it was always the higher coupon they tended to track. As time passed, people started to understand that to deliver into that contract didn't take the cheapest issue. The optimal delivery was a combination of Ginnie Maes - ones with different coupons. It wasn't clear what could be delivered, and then it wasn't clear what should be tracked. Things were further confused because you have a very welldeveloped forward Ginnie Mae market, which people were using as well. I understand a new Ginnie Mae contract is being designed and will start trading soon that is going to be more like the bond contract. And youl1 get real Ginnie Maes on delivery rather than just a receipt. Hopefully, that will work out better. In the meantime, people are hedging mortgage and Ginnie Mae portfolios with the ten-year note more often than with the Ginnie Mae contract.

Stock Index Futures: A Portfolio Strategy Tool DavidM. Dunford, CFA The growth of financial futures markets both in terms of size and liquidity has been rapid by any standard of measurement. From the initial trades in early 1982, the markets for stock index futures contracts have grown to the point where the underlying market value of index futures traded regularly exceeds the market value of stocks traded on the NYSE on a daily basis. The broad range of possible strategic uses of stock index futures in portfolio management indicates continued rapid growth over the foreseeable future.

classes increases the return per unit of risk. A second passive technique involves diversifying within an asset class. Adding representation in additional segments of homogeneous securities within an asset class adds return-to-risk benefits similar to adding additional asset classes. The segments within an asset class do not always move in the same direction at the same time and diversification benefits can be derived accordingly. Active

The role of stock index futures as a strategy tool should be viewed within the total process of portfolio management. The goal of portfolio management is to achieve the maximum investment returns for a predetermined appropriate investment risk exposure. Futures are important investment instruments which contribute to return by facilitating strategic portfolio moves and by controlling risk in a timely, costeffective manner. The focus of this presentation will cover three areas: (1) a brief review of the general strategies and techniques for maximizing portfolio return; (2) the role financial futures can play in maximizing portfolio return; and (3) a discussion of a number of practical applications for stock index futures in portfolio management. STRATEGIES FOR MAXIMIZING PORTFOLIO RETURN There are four general techniques or strategies for maximizing the return of a portfolio - passive, active, insurance, and implementation.

The general strategy of active management can also be divided into two areas. The first is selection of individual securities or groups of securities that are believed to be mispriced. There is an expectation that excess return can be generated with minimal additional risk due to the perceived mispricing. A second active strategy involves asset class selection. This involves shifting the asset mix of a portfolio toward the more attractive or undervalued asset class. Insurance A third general technique involves insurance strategies. The portfolio benefit of insurance arises from two sources: (1) the ability to shape return patterns of the portfolio to more precisely reflect an investor's utility function; and (2) the potential to advantageously buy or sell insurance that is mispriced.

Passive

Options perform this insurance function and all option activity is some variation of it. A portfolio manager buys insurance if options are purchased and sells insurance if options are sold.

Passive strategies are of two types. One involves diversifying across asset classes by adding additional asset classes to a portfolio. Return can be enhanced by this strategy due to the nonperfect correlation of the asset classes. Because asset classes are not perfectly correlated, risks are partially offsetting with the result that adding more asset

Applications of option buying strategies include: (l) buying put options on securities in a portfolio, and (2) buying call options with a small portion of a portfolio's funds while holding the remaining assets in cash equivalents. There is also a group of option buying or insurance strategies where option contracts are not actually involved but

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are replicated through active trading often requiring high turnover.

Costs of Strategy Implementation and the Role of Financial Futures

Applications of option selling strategies include overwriting, or selling call options on securities held in either an actively managed portfolio or in a passive index fund.

There are four costs which could be incurred during the implementation phase. These costs are best illustrated by way of a simple example. Assume that we wish to increase a portfolio's exposure to common stock by $80 million. There are two methods to do this. One method is to buy $80 million of common stock in the stock market. A second method is to buy $80 million of equivalent stock exposure through stock index futures. Assume that an S&P 500 stock index future is currently selling at 160. One future is therefore equivalent to 160 times $500, or $80,000 of common stock exposure.

Implementation The fourth and last general strategic category for maximizing portfolio returns involves implementation. All the strategies and techniques encompassed in the other three general categories passive, active and insurance - have to be implemented. Both observable and unobservable costs are incurred during implementation. These costs, perhaps, are higher in the active and insurance categories due to higher portfolio turnover characteristics. The contribution a strategy or technique makes to maximizing portfolio return must be calculated net of implementation costs. Since there can be considerable friction or loss of return depending upon the amount of activity necessary, some portfolio moves or strategies may not be worth making, or the apparent expected returns may not be capturable because of implementation costs.

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Implementation strategies where the actual securities are involved have revolved around particular trading techniques, primarily passive in nature. These trading techniques seek to minimize transaction costs and to capture as much as possible of the portfolio return advantage that the passive, active, and insurance strategies offer. Considerable work has been done in this area and transaction costs have been minimized to a significant extent. A second method of implementing strategic judgments and techniques involves futures instead of the underlying securities. This is the important role that futures can play in a strategic sense in a portfolio. Futures offer an alternative means to buy or sell stocks or to increase or decrease stock exposure. In order to better understand the return advantages which would accrue to utilizing stock index futures, a closer look at the costs of implementation and the alternative ways of implementing portfolio strategy is warranted.

Implementation Costs The first cost is commissions. If we assume that the average price per share of a common stock is $40, a purchase of $80 million of stock under the first method involves buying 2 million shares of stock. If we further assume a commission rate of 5 cents a share, a rate currently lower than the average for all institutional trades, the method would involve total commissions of $100,000. The second alternative is to buy $80 million of stock exposure by purchasing futures. Given our example that each future is equivalent to $80,000 of common stock exposure, then 1,000 futures contracts would be needed. The commission to buy 1,000 contracts is one half the round trip commission of $30 per contract, or $15 times 1,000 contracts, for a total commission of $15,000. Commissions are reduced 85%, a significant savings, by utilizing futures tha t will add to return. A second cost is market impact. This cost is less observable than commissions and more difficult to measure. A stock purchase of $80 million can be expected to have an impact on the price level of the shares; you may have to pay up an eighth or quarter in order to transact. The market impact of buying 1,000 S&P 500 futures contracts can be expected to be less because of the greater relative liquidity currently observable in the futures markets. At current average trading rates of 35,000 to 45,000 contracts per day, the underlying market value of the S&P 500 futures market is approxi-

mately 25% greater than the market value of shares actually traded on the New York Stock Exchange. It can be expected that the purchase of

1,000 contracts can occur at or near the current market price. A third cost, even less observable, is time. Because of the size of our program, it can take time to buy $80 million of stock - time during which our strategic opportunity may erode and the portfolio will be at an investment risk level different from that targeted. Given the relatively greater liquidity of the futures market, it would take less time to purchase futures contracts than to buy the stock outright. The fourth important cost is perhaps the least observable of all - the cost of disruption. If the first implementation method of actually buying -common stock is chosen, the $80 million must come from somewhere. Perhaps, the $80 million is coming from a portfolio run by another manager or from part of a balanced portfolio. Such a large transfer from one pocket to another will cause significant overall portfolio imbalance for some time period, during which the whole will not exactly reflect the investment judgments of the investment managers. The result could be the loss of at least a portion of the incremental return expected from undertaking these investment judgments. Implementation using futures does not require the movement of funds of such magnitude. Potential disruption and loss of incremental return is accordingly minimized. futures as an Implementation Tool

the cash invested in stocks today. The investor plans to hold the stocks for a time period which includes the expiration date of a certain stock index future. The investor has two alternatives: either buy the index of stocks today through an index fund and hold the index fund for the time period, or hold the cash equivalents and buy futures for the equivalent amount of stock market exposure. In the second alternative, at the time the futures expire the investor will own the monetary equivalent of the index of common stocks. Since the investor ends up holding the common stock index, or its equivalent, in each of the two alternatives the returns obtainable from the alternatives are equivalent. The appropriate pncmg or valuation formula for a futures contract can be derived. In the first alternative the investor would receive the capital gains or losses on the index plus dividends: Returnl = Index Price at Expiration - Current Index Price + Dividends = IE - IB + D In the second alternative the investor would receive capital gains or losses on the futures contract plus interest on the cash holdings. Returnz = Futures Price at Expiration - Current Futures Price + Interest = FE - FB + Rf It is important to note that the price of

the index (IE) will equal the price of the futures (FE) at the point of expiration. Equating these returns and solving for today's price of the future (F B), one obtains this relationship:

The four costs: commissions, market impact, time, and disruption, can be significant drains on portfolio performance. Futures offer an alternative for strategy implementation and cost minimization. Essential to this assertion is an assumption that buying or selling stock index futures is an alternative or is equivalent to increasing or decreasing stock exposure by buying and selling stocks. A review of the derivation of the valuation of a stock index future supports the validity of this assumption.

Today's futures price equals the price of the index, plus interest obtainable on a risk-free basis over the life of the contract, minus the dividend expected to be received on that index over the life of the contract. If we combine the last two terms, interest minus dividends, the direct arithmetic relationship between the price of the future today and the price of the index is apparent. As one moves, the other should move in step.

Assume an investor holds a given amount of cash and wishes to have all

The futures contract is a proxy for the index. Owning a futures contract is

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Figure 1 S&P 500 Future (Dec. '83) Vs.S&P 500

PRICE $210 200 190 S&P 500 FUTURE (DEC. '83)

180 170 160

S&P 500 150 140 130 6/16

11130 TIME (WEEKS)

equivalent to owning a certain amount of stock exposure. Figure I offers a view as to how the S&P 500 has moved over the time period from June 1983 through November 1983 versus the price of the December S&P 500 contract.

While not exhaustive, the five are representative of the types of strategic uses of stock index futures and financial futures now available to portfolio management. Index Fund

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The two lines are virtually interchangeable. The chart indicates how close the prices of the two instruments have been to each other. The area between the two lines represents where there has been a difference between the S&P 500 price and the price of the fu tures. Differences have and will occur. On average, however, it can be expected that the futures price will be a very close approximation of the price of the S&P 500 index. Owning one is essentially equivalent to owning the other. PORTFOLIO APPLICAnONS There are a number of strategies or techniques where utilizing futures offers implementation advantages and incremental returns to portfolios. The following reviews five such applications.

The first application involves a common stock index fund, a portfolio construction technique which was included in the passive management category of return maximizing strategies presented earlier. A superior method of constructing an index fund involves buying S&P 500 futures contracts. A numerical example will illustrate the construction mechanics. Assume we wish to structure an index fund of $100 million and that the current price of the S&P 500 future is 170. Each contract is therefore equivalent to a common stock exposure of 170 times $500, or $85,000. To gain exposure of $100 million in common stocks, one could easily and quickly purchase 1,176 S&P 500 futures contracts, or $100 million divided by $85,000.

There are many advantages to such a portfolio construction approach. The benefits of lower transaction costs have been mentioned previously. The low commission rate on futures trades and the high level of liquidity in the futures market offer the potential for significant cost savings. Second, portfolio construction via futures contracts offers the advantage of actually buying the index. When index futures are purchased, exposure to all 500 stocks is also purchased. Also, since buying a futures contract is equivalent to buying the index at all points in time the portfolio is no longer exposed to changes in the names of the 500 stocks included in the index. The recent change in the composition of the S&P 500 due to the AT&T break-up illustrates that such changes may not be insignificant or trivial. A third significant advantage of the futures approach to index fund construction is that there are no dividends to reinvest. Periodic rebalancing of the index fund due to cash dividends is not required since the futures approach does not involve the receipt of dividends. As indicated in the comments on valuation, dividends are already priced within the futures contract. Deposits to a Portfolio A second application of futures involves cash contributions, or a large deposit to an existing portfolio. Buying additional common stock with a sudden large cash inflow may take time - time during which one is exposed to significant market moves. We have seen examples of this in the recent past. Any portfolios that were started with cash in the last quarter of 1982 or early in the first half of 1983 most likely underperformed the market, perhaps significantly, because in the rising market it took time to fully invest the cash contribution. Stock index futures offer an attractive alternative. Assume on Day 1 that there is a $50 million deposit to the portfolio. This deposit could immediately be invested in the stock market and the desired stock market exposure achieved by buying $50 million worth of futures contracts. Given the assumptions of the index fund example, this would be accomplished by buying 588 contracts. These contracts can then be sold off as

desired individual issues are purchased for the portfolio. Assume that such stock purchases occur evenly over a tenday period from Day 2 through Day 11. On each of these days, a portfolio manager buys $5 million worth of attractive stocks and sells one-tenth of the futures contract position, or approximately 59 contracts. The desired stock market exposure of the portfolio is maintained at all points in time. The important point illustrated in this application is that futures offer a significant means to control the risk level of a portfolio and to reduce exposure to unintended risks, unintended investment judgments. For example, the manager's investment judgment may have been to be 95% invested in stocks over a certain time period. Because of the large deposit and the time it might have taken to invest it in attractive stocks, the portfolio may have actually been only 80% invested. An important penalty to incremental return would have been incurred that could have been avoided through futures contracts. Beta Control A third application, similar to the second, involves implementing an active stock market judgment. Assume that a portfolio manager has a positive outlook for the stock market and wishes to raise the exposure of the portfolio to the exposure of the market, or raise the portfolio's beta, as a consequence. An example will illustrate the alternative methods of implementing this strategic decision. Assume that the manager has a $20 million portfolio with a target beta of 1.2. Assume also that the beta of the present stock component is 1.1 with stocks currently representing 95% of the portfolio with the remaining 5% in cash. One way to move the portfolio to the beta target of 1.2 is to sell a number of the lower beta stocks and buy an equivalent amount of higher beta stocks. This procedure maintains the stocks at 95% of the portfolio, but raises the stock-only beta to a number such as 1.25. The result would be a portfolio with a beta of 1.2, but implementation could be a long and costly process. Not only would significant turnover likely occur, but only a certain few stocks would have the required attractive characteristics.

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The alternative approach is to raise the beta by buying an appropriate amount of stock index futures. Under the pricing assumptions used in the previous examples, one need only purchase 36 S&P 500 index futures. The appropriate number of futures to purchase (X) results from the equation: ($19 million)(l.1) + ($85,000)(X) = ($20 million) (1.2) The advantages of controlling beta in these circumstances by using stock index futures are the following: (1) the target beta of 1.2 could be achieved almost immediately and the portfolio would then be constructed to reflect the desired investment judgments; (2) the transaction costs would be considerably lower, particularly since turnover could be very high in trading the lower beta stocks for the higher beta stocks; and (3) the optimal stock mix would be maintained. This last advantage is extremely important. Presumably, the stock component with a beta of 1.1 represents the optimal mix of stocks with the highest alpha potential. By selling low beta stocks and buying high beta stocks the portfolio manager most likely is adding stocks with lower alpha expectations to the portfolio. The manager may be reducing the expected alpha of the stock component and therefore giving up the potential incremental return from the stock selection judgments. This loss of incremental return is avoided by achieving the portfolio target beta through buying S&P 500 futures. 60

Asset Allocation A fourth, and very exciting, futures application involves asset allocation.

Assume tha t the manager of a large portfolio wishes to change the stock/bond mix to reflect new investment judgments. An example of this application is illustrated in Figure 2. Assume that the mix today of a $300 million portfolio pension fund is 70% in stocks ($210 million) and 30% in bonds ($90 million). Assume also that the manager's judgment calls for a lowering of stock exposure and a raising of bond exposure by 5% of total value or $15 million in each asset category. In order to achieve the new target of 65% in stocks and 35% in bonds, one would have to sell $15 million of stocks and buy $15 million of bonds. There are two ways of implementing this strategy. The traditional way would be actually to sell $15 million in stocks in the market and buy $15 million in bonds. The alternative way would be to use futures, selling the equivalent of $15 million of stock exposure by selling stock index futures and buying the equivalent of $15 million of bond exposure by purchasing Treasury bond futures. If it is assumed that one stock index future is equivalent to $85,000 of stock exposure and one Treasury bond future is equivalent to $70,000 of bond exposure, this would involve the sale of 176 S&P stock index futures contracts and the purchase of 214 Treasury bond futures contracts. In addition to the advantages of lower implementation costs and quicker implementation there are important advantages to implementing asset allocation judgments through the use of futures. The first is that disruption is minimized, a particularly important consideration if fund assets are held in

Figure 2 Asset Allocation Application

Fund Size = $300 Million Actual Mix Stocks Bonds

Target Mix

Net Change

70% (210 Mil.) 65% (195 Mil.) $-15 Million 30% (90 MiL) 35% (105 Mil.) $+15 Million

portfolios run by a group of external investment managers each specializing in either stocks or bonds. By using futures to implement the stock/bond decision, the external managers are not affected: they need not even know the activity is occurring. The futures can be managed outside of the multiple manager structure. A second advantage is that less money need be involved to alter the asset mix due to the leveraged nature of a futures contract. Assume that the manager of the $300 million fund may alter the stock/bond mix within a + 10% range around some long-term normal mix, such as 70/30. Asset allocation changes of this degree could be accomplished using the futures approach with approximately $7 to $8 million of cash necessary for margin requirements, while $60 million would be required via the buying and selling of stocks and bonds. More funds can therefore remain available to the specific security selectors for the production of additional alpha return. High Turnover Strategies The fifth and last application is very general. This application is the use of futures in high turnover strategies involving constantly changing market exposures. An example would be a put replication strategy based upon replicating the hedge ratio, or market exposure, of a put option on a portfolio. In order to constantly replicate this continuously-changing hedge ratio, high turnover is necessary. The amount of turnover and the activity necessary within this strategy is dependant upon the market's volatility. The cost of implementing this technique can be greatly reduced by increasing or decreasing market exposure through buying or selling stock index futures. Summary A number of strategic applications for using stock index futures and Treasury bond futures in portfolio management have been reviewed. Utilizing futures facilitates the implementation of a strategy or technique within a portfolio. Futures add to the incremental return of a portfolio through lower commission

costs, immediate implementation of the strategy, a lower market impact or cost due to execution and finally, minimization of disruption within the portfolio. Stock index futures and bond futures can playa key portfolio role. They offer a means to reduce exposure to unintended risk and to manage risk in a timely, cost-effective manner. They are important new vehicles within the spectrum of investment instruments available for effective portfolio management.

**** Question: You mentioned the 90/10 strategy. Is that primarily with Travelers' own money, or with pension fund money? And if it's pension fund money, how do you talk them into doing it? Mr. Dunford: The 90/10 strategy that you're referring to, of course, does not relate to futures activity. It is an option activity which involves 90% of the assets of a portfolio being invested in cash or cash equivalents and 10% in call options, with periodic rebalancing towards that 90/10 proportion. We have a significant amount of assets under management using that technique. It started out using Travelers' own assets, but now these represent a minor portion of the total assets under management, with most of the assets being pension-related. How do we "talk them into it?" We just very carefully explain all of the benefits that are there in an insurance strategyinsurance in the sense of limiting your participation on the downside, while being able to participate to a relatively full extent in the upside, with the ability to add incremental return from the stock selection underlying your option selection. Performance has been good versus the performance of the S&P 500. Question: You talked about short-term asset allocation decisions, where the period you look at is less than 30 days, or 90 days. What is the tradeoff with a longer-term asset allocation decision, where you have to roll over these otherwise short-term asset allocations?

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Mr. Dunford: It is certainly very dependent on the assumptions you make in that kind of analysis as to turnover and so forth. We have been looking at it more in terms of an index fund approach and trying to simplify the analysis a little bit. The rollover required to get the lion's share of the liquidity for

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stock index futures is in the near-term, three month contract. Recognizing this, our break-even point, just looking at commissions and market impact, is in the two- to three-year range. At least this is what some of our initial studies would indicate.

Looking Ahead - New Financial Instruments for Modifying Risk and Enhancing Return

PANEL DISCUSSION Dr. Murray: Remember now, we're looking ahead, thinking about the future. This is your opportunity to ask questions about where we seem to be headed, what the future opportunities and problems will be. Since we're talking about forecasting the future, we won't hold the panel to complete infallibility in these forecasts. Well just ask them for their best judgments. I'll start by asking about the high liquidity in the short-term contracts due to heavy dealer participation. As you go out to the longer expiration dates, you observe that volume declines quite rapidly. Yet many of us, as portfolio managers, are interested in six'months, nine months, and many times we wish we had a year or longer. Is that market and its liquidity going to grow to accommodate institutional portfolio management interest, as opposed to the liquidity and activity suitable for the dealer market? Mr. McAdams: I think that the probabilities favor an increase in the liquidity in those contracts greater than three months - a significant increase. This is primarily because the role that futures play and can play in institutional management is really only now being appreciated. Only now are the first steps being taken to actually get futures broadly into portfolios. I would fully expect that the liquidity will grow over time to make six- and nine-month contracts, at least, available. Mr. Shultz: If you take the subset of uses by plan sponsors, we will be using futures markets in each plan with a unique set of managers and a unique set of objectives in ways that are based on capital market expectations. That would appear to bring volume into those contracts, probably distributed on both the long and short sides. Because we're not there now on the capital market expectations point of view, is that a different use of the market? Dr. Kopprasch: I'd like to add one point

to that. I agree that as some of the institutional barriers have come down we have seen more volume. There is, at least in the bond futures area, more liquidity in the longer contracts than may appear at first glance. You can enter into the earlier contracts and then do spread transactions. While there's not an active market outright for the back contracts, there is a fairly actively quoted spread market. For example, you can get yourself into the large contracts and then do March-June or JuneSeptember spreads to move yourself further out, if that is where you want to be. You might do this to target some forward sale at a deferred date. There are some things you can do to enhance liquidity if it appears to be absent. Dr. Hanson: The same thing is true in the equity markets. In the S&P futures for example, the spread between the December 1983 and the March 1984 contract prices for a long period of time was about $1.40. Now that spread is close to $2.40. Since you have a full quarter, the theoretical value of that spread should be one quarter's interest rate minus one quarter's dividend yield. Using a 10 percent interest rate minus a 4 percent S&P yield, that's 6 percent. If you divide by four, that's 1.5 percent; 1.5 percent of an S&P contract at 160 is $2.40. That's just about the right value for the spread. For a long time the spread was cheap, and because it was cheap, people did start to roll the contracts, picking up alpha on the roll. As more people did that, the spread started to widen. It was interesting that it was cheap, because in this particular case, since you have a full quarter, you don't have to worry about the unevenness in the dividend pattern. Question: I'm curious to know what changes you foresee in performance measurement systems that are applicable to using these new instruments. Mr. McAdams: I assume you're referring to the consultant-driven performance measurement products that are for sale. I think we all know how to calculate a time-weighted rate of return to

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include options and futures. The threeinch-thick document that analyzes the performance of your portfolio over the last 90 days, looking at it every which way, upside down and sideways, will be obsolete. There are very few performance measurement firms that have figured out how to include option strategies within their performance measurement systems. I think they will have to change dramatically to remain viable. I have that problem all the time when I'm using options in a pension fund and the consultant says things that I don't recognize because he doesn't measure what I'm doing. Mr. Shultz: One can use futures to build a perfect hedge to hedge the market and the manager's unwanted exposur~s. You would be buying the alpha and, therefore, the measurement product would take care of itself. You don't want to use futures for that reason, because there are tools available to construct benchmark or normal portfolios. They will give you the same ability to do what I would not term performance measurement, but performance attribution. I would submit that the issue in looking at the manager's return is performance attribution. If this doesn't work and we can't get managers to work with us in developing benchmark or normal portfolios, the ultimate solution is to write futures contracts against the manager's returns. And that's going to happen anyway.

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Dr. Murray: One example of a new measurement approach is to consider an optioned equity portfolio as a bond substitute, running it against the Lehman Kuhn Loeb total return and comparing its volatility. Question: How many people outside of the brokerage houses can account for what is going on, much less explain it to management? Let's say you put on a short hedge against an equity market and you do it outside your equity manager. He goes up 55 percent. You look at this one little account and get the report from managemen t that you just lost $30 million. But the equity manager is very happy about it, because he made $70 million on his account, and he got exactly the risk exposure he wanted. It's the separation of the two parts in an accounting and a perform-

mance measurement sense that Lloyd McAdams is talking about. People don't understand that there are now two parts that you have to put together. Dr. Murray: In essence, you really have two accounts that should not be looked at separately at all. They have to be looked at in combination. Mr. Abramson: The Becker-type measurement services that have been trying to measure the options manager have been relatively unsuccessful so far. Even the options societies haven't really determined what they'd like to see done. Unless you are talking about an overwrite options manager, where you know exactly what the incremental return has been, over and above anything else, you really can't separa te the two. It is just another investment tool. Most kinds of option activities - option writing, option buying, or whatever are other investment tools, and you really should not try to separate the investment techniques. It's one investment account using various kinds of investment techniques, and I really think that's how it should be measured, against the objective of the account. Mr. McAdams: I guess I've seen some unusual and innovative ways of explaining poor performance in options management to make it look good. I think of one options manager, who will remain nameless, who has a habit of explaining his return in terms of dollars received. His clever way out is to let all the stocks get called away and create the option premium as the incremental return. Interestingly, quite a few people find that to be quite acceptable. This shows me that the issue of performance measurement and options really hasn't been analyzed much. I think when that happens, the naive approaches, which almost take advantage of people, will soon go away. Mr. Dunford: We are very involved with strategies in futures and options for pension funds that involve a number of master trustees. The master trustees - banks, generally - do have the facility to account for part of the money that we are actually managing and impacting on a separate basis. What we're doing is providing the pension fund sponsors with the totally inte-

grated portfolio performance attribution numbers that we've talked about. It may be a little while before master trustee banks can get there. Mr. Shultz: Just to pick up on that point. I'm not being critical of anyone bank, but of the industry in general. I'm not sure most of the banks can really carry the assets across, never mind the performance attribution. That's the back-end issue. The front-end issue is getting the accounting systems to account for the profit. By that I mean that some banks don't have the ability to run liability accounts, which makes the reports on these things rather funny looking. Dr. Kopprasch: Still, things have come a long way from the beginning in options. A colleague of mine who then worked at another firm managing money sold covered options very early in the game and did some covered writes. He went to buy them back at the end and was prohibited from doing so. He was told that he had the right to sell covered calls, but he was not allowed to buy options. Things have come a long way since then. I expect that the accounting and performance will come along similarly. Mr. Shultz: A final remark on that one. Our own program did $200 million short and then bought it back. The trustee bank was very pleased because we did it intra-month, which means that none of it ever went through their accounting system. They felt that if we had done it at month-end, they would have had no idea how to do the accounting on it. Question: Would you discuss what you think the outlook is for sector or industry futures? Are we going to see more of them? Is liquidity going to improve? And finally, what sort of strategies might you use there? Dr. Hanson: So far the only futures contract on an industry group that has traded is the New York Stock Exchange Financial Index. That was an unsuccessful contract, trading for about three months before trading was suspended. As you know, there are several industry group options. I would have guessed that options on the energy subgroups

would have been the most popular. However, that whole sector seems to be out of vogue, and perhaps that's why the index hasn't been popular. The computer technology index option has been a fairly successful contract. There is concern about an overproliferation of different types of futures on subgroups, and so forth. A moratorium of sorts is in effect right now, which I believe will prevent any exchange from introducing more than two new products until March 1984. There have been many interesting proposals, including a futures contract on the Consumer Price Index [CPl]. I think it would be an extremely interesting contract, because it would be a way of backing out people's expectations relative to the real rate of interest. You asked about applications. Clearly, you could use them to conveniently overweight or underweight a portfolio in a particular group, such as the energy area or the computer area. Dr. Murray: To expand on the question, does it imply that you must have a broader range of these industry indexes before you will develop a high level of activity? I mean, if you're really going to do a sector rotation kind of equity portfolio management, it almost implies that you've first got to have a pretty complete range of sectors to use. Dr. Hanson: Well, I guess ultimately it would come to that. Again, there is the problem of just being overwhelmed with too many products all at once. Of course, it is still possible to overweight the sectors by actually buying or selling individual stocks. Down the road, though, I would agree with you. Mr. Abramson: Those of you who had a chance to read today's Wall Street Journal may have noted that the Philadelphia Exchange is coming out with a hotel and casino index! To answer the question, I think that more activity will be generated as additional industry indexes come out. The entire industry is expanding. More products, more commissions. Question: If a multi-manager plan uses futures just to capture the specific performance of the managers and retain the positive alpha of those managers,

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how do you maintain the equity exposure for the portfolio? Mr. Shultz: Wouldn't it be nice if we hedged the open market out of our total portfolio? No, that wouldn't be too much fun. Obviously, you have to ration out the equity based on exposure. I don't think anyone would have the intention of going forward and completely hedging all of their managers' accounts. I think that it needs to be a very selective thing. But you're right, across-the-board you would now practically remove yourself from the market. That's obviously not really where you want to end up. Question: From the standpoint of the plan sponsor, if you use these contracts to diversify or hedge your equity exposure, what's left for bond investing other than trading or as a cyclical play? Mr. Shultz: We need to ask why the bond portfolio is in a pension fund. Is it there as a non-investment decision to diversify and to hold down the risk level, or is it there from an investment decision point of view? If it is truly in a fund just to dampen the volatility, I'm not sure there is a real role to play in the future. I guess what is there as an investment strategy or investment alternative might stay. And, you have the correlation question. Bonds are there because of low correlation with other asset groups. I'm not sure that would ever go away.

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Mr. Dunford: I want to second that. I think that as long as bonds don't achieve something like a correlation of .8 or above versus the common stock market, there will always be a long-term asset allocation role for bonds in a larger pension fund. This would be true as long as the resultant risk level is within the boundaries that a pension fund wants. Mr. McAdams: I would like to describe an investment strategy which we use for a large number of the balanced accounts. I normally wait for the client to raise the eternal question, "Are bonds any good any more?" Whenever they say that, I respond as follows: "We have an investment technique which uses stocks and options, and we feel that it has the potential to provide a rate

of return 3% to 5% above the commercial paper rate over long periods of time." That's the strategy. According to most capital market theory, long-term bonds will provide a rate of return 3% to 5% above commercial paper over a full market cycle. We think that this strategy will do it with half the volatility and much better diversification. The thrust of the question is right. If bonds have a one-to-one correlation with stocks, they accomplish nothing for you. So I think that option strategies, particularly if a good equity manager is using them, can very easily provide a superior alternative to long-term bonds. Question: Are options on actual bonds going to survive? Will options on futures become the only way to hedge fixed income securities? Dr. Kopprasch: Our traders have generally expected that options on futures themselves would be the prevailing instrument for a number of reasons, primarily because of the liquidity that's necessary on the floor where these options are traded. An option on an actual bond traded on the Amex or on the CBOE is traded by somebody who doesn't have immediate access to the underlying instrument. People on the trading floor cannot have broker screens because they're not dealers in government securities, at least not as traders. They can't even get an up-to-the-minute quote other than a Telerating, which is not enough to permit a quote. So, it's difficult to make a market. It's difficult to layoff the risk immediately if you're doing some sort of a hedge strategy. With options on futures, the options and the futures are traded in pits right next to one another. It's very easy to take on the risk in one place and lay it off in the other. So, you can make a very active market, take a lot of positions home if you must and still be riskneutral. You can be long futures, short calls, and long puts and go horne every night flat, even though you've got an open interest of 5,000 in each instrument. So I think that's what tends to make options on futures so much more liquid. There are also some potential delivery problems when you've got an option under one specific bond. Even the futures contract doesn't have only one

deliverable bond, as the contracts are structured now. Options on cash bonds are still structured with just one deliverable bond. In the bond market, we're doing a fair number of over-the-counter options for people who want to tailor the maturity sector. It's like 1973 when there wer'e only over-the-counter options. Maybe there aren't enough people out there who want options on five-year maturities to have a viable secondary market, but there are enough when you have a known risk over a known period of time - a three-month exposure to a five-year rate, for example. That's the kind of thing that could be hedged. So, there are those other option opportunities as well. Question: Is there a prospect for a futures contract on a market index for a fixed income security? Dr. Kopprasch: I'm not sure that anybody agrees yet what index actually represents the fixed income market. I think it would be fairly difficult to come up with any kind of a futures contract on the index itself. In effect, you're talking about a future on a CPI. That is certainly nothing you can either trade against or arbitrage. It's really neither. When you're trying to make it something that you can match, that can hedge away certain kinds of risk, then you want to be able to have an underlying structure that resembles that index. I'm not sure that anybody necessarily wants that kind of portfolio. I think that you can look at the Treasury bond futures as a market index contract. It does not capture quality spreads, corporates to Treasuries. Nevertheless, the bond market is the bond market in general, and the Treasury bond futures contract seems to capture most of the movement of the market. I often talk about futures as if they're simply an index of government bonds and treat them in that way. I think we already have a sense of short-term and longterm indexes at eight to ten years now. Ms. Owens: The market is very efficient at eliminating the contracts for which there's no real economic need. If the need isn't there, even if they create a contract, it won't trade.

Question: I'd like to ask if any of you have done work in the area of hedging municipal portfolios? Dr. Kopprasch: We have looked at hedging municipals, and at hedging preferreds along the same lines. Our initial look was in our own positions. We wanted to reduce the risk when taking on massive positions with a large carry. You can reduce the risk in general with bond futures against municipals. However, you cannot get a very close fit. There are people on the street that will tell you that you can eliminate 80 to 90 percent of the risk. If you are being told that, come to me and III tell you what's wrong with the mathematical technique that generates that number. It's a problem in the regression analysis that's not being recognized. It simply isn't possible to hedge away that much risk. You can hedge some of the risk remaining after the tax effects are taken into account. It's an attractive technique, but it's certainly not a close fit. It isn't the kind of hedge structuring that someone could be proud of. Question: I wonder if you could clarify references to dividend capture strategies in options? Could you comment on what's happening with the overthe-counter equity options now? Mr. McAdams: A specific example of a dividend capture is probably the best, and I will mention applicable laws as we go. Assume we buy IBM common stock at $121 with the ex-dividend date two weeks from today. The dividend is $.90. We sell the $110 option against the $121 stock (buy stock, sell call). The net price of this transaction will be something like $108.5 or $109, because there are some time premiums involved in this contract, which is out 100 days. This in-the-money call has very little risk unless the stock goes down below $110. Clearly, there is risk relative to the $.90 dividend you're going to earn. In that sense, there is certainly no guarantee that you're going to make money. What will happen is that if you own the stock on the ex-dividend date and collect a $.90 dividend, the price of the stock will

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go down. Interestingly, the price of the option will not move the same amount as the stock. This is a relatively low-risk transaction, but it is by no stretch of the imagination riskless. The net effect will be that from point A to point H, your rate of return will be something that is slightly above the commercial paper rate. The issue, however, is that the bulk of the return will have come from the $.90 dividend that you earned. You may even have earned it this way: a $.90 dividend and a $.40 $hort-term capital loss, for a net gain of $.50 over three weeks. When you annualize that $.50 over a year, it's 13.5 percent. From a tax perspective, you have an 85 percent taxfree dividend of $.90 and a $.40 capital loss. That has a higher after-tax rate of return than getting 13.5 percent from a Treasury bill. I warn you, if this sounds particularly good, there is substantial risk involved in this transaction. Try dividend capture with a stock that begins trading down 5 or 6 points. You will lose. Question: What about a preferred stock strategy?

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Mr. McAdams: The preferred stock strategy was the first and has been going on since the beginning. Niagara Mohawk has a preferred stock that pays four dividends a year; it is a non-sinking fund preferred, it is like a perpetual bond, and it pays $1.00 every quarter. So, a corporate treasurer goes in a month before the dividend is paid and buys the stock. He holds the stock for a month, collects the dividend and then sells it. The dividend is 85 percent tax free. The only problem is that the stock went down $3.00 as interest rates were going up. He gets an 85 percent tax free dividend and a $3.00 loss. In no way does that compare favorably to investing in Treasury bills. When interest rates are going up, it's a terrible strategy; when interest rates are going down, it's quite magnificent in the eyes of the corporate treasurer. Unfortunately, he has to forecast interest rates. It might be interesting to do a preferred

roll strategy using futures. You might be able to get rid of some of the interest rate risk. This has interesting potential,

and is one of the areas I see the dividend capture business evolving toward. I don't think anyone has mentioned the favorable tax treatment you get by buying a preferred stock, catching the dividend, and selling a futures contract against it. I don't know many people that are using that strategy. Mr. Abramson: Although this is an options and futures seminar, I must mention that one of the hottest areas of dividend capture right now is in the adjustable rate preferred area. Adjustable rate preferreds have dividend rates that are reset quarterly based on Treasury interest rates. Many corporate treasurers are using this particular vehicle for a dividend capture program. If you reset your dividend, your principal remains relatively stable. This way, you eliminate the interest rate risk. Dr. Kopprasch: I can't address the issue with very many specifics, but our preferred desk used to do over-the-counter options on preferreds. So, it is possible to combine some options and preferreds in the portfolio which will leave you basically flat with regard to price risk, but you can still capture dividends. You cannot, however, own a put on a preferred and still take a tax-free dividend. Mr. McAdams: There are no puts in dividend capture programs. Only under extraordinary circumstances could you use a put, for instance when no dividend is being paid. Mr. Shultz: Can I turn around and ask a question relating to that marvelous discussion? What do our friends in Washington do when we've used up all of these strategies and the corporate tax intake drops to zero? Mr. McAdams: They do exactly what they're doing now. Senator Dole and his Senate Finance Committee are contemplating a perceived abuse by the Chrysler Corporation. They had a preferred stock that was in arrears. They paid a huge dividend equal to half the value of the stock. For reasons which I assume are politically obvious, Chrysler could provide such a windfall to corporate investors because they had accrued their dividend. This was the subject of a Senate investigation.

Things may well change, so I certainly would not encourage anyone to start a business based on present law. The corporate tax rate will never have a chance to go to zero. The law will be changed. The holding period will go to one year, or something of that nature, if it is perceived that investors are not taking a risk. If you tried this with Digital Equipment, you could have lost a lot of money. Question: I believe the Dole bill also proposed extending the holding period to qualify for the exclusion from 16 days to a year. Dr. Murray: Needless to say, that would put an end to options transactions. Mr. Abramson: I'd like to add to this. It was Senator Dole's Senate Finance Committee staff that made this proposal. Think of what that would do, if the proposal really extended the holding period from 16 days to one year. It makes adjustable rate preferreds, preferred stocks, utility common shares, and any high-yielding stock which pays a dividend, much less attractive. It changes the entire investment structure of high-yielding securities. That was pointed out to the Senator by a lot of lobbyists and I think the proposal has been dropped for good. Question: When you're looking at beta in the options area, how do you account for the difference in the distribution? You don't always have a normal distribution of price returns. Any truncated distribution will have a lower beta. I'm not sure that this necessarily translates into lower risk in the sense that most people think of when they think of beta. What happens to your tracking? If your beta goes to .7, does your R 2 go to 50%? How can those things interact? Mr. Dunford: The investment community is finally moving up, and figuring out that there are more than two numbers that describe an outcome distribution. You are going to have to figure out new ways to describe expected returns and their distribution in the future. It's not going to be just beta and

alpha. They are only two numbers that people talk about, not the only numbers. I think what you are going to end up with is presenting things to a statistician. They sit there and say, "Just give me the outcome distribution and I'll give you a picture worth a thousand words." You've already tried to take your picture and get it down to two numbers. Now, you're going to have to deal with a world that has pictures of thousands of words. Mr. McAdams: I think that the numbers which involve second moments, the variance and standard deviation of distributions, really have be taken with a grain of salt when looking at a return distribution. These numbers may be very heavily skewed at the third moment. The beta and correlation numbers are children of the second moment. They are dependent on the standard deviation. But option and insurance strategies do not have a skewness of zero. In essence, correlation and beta are not that relevant. When you're trying to combine options with an asset class having a normal distribution, you are going to have to move more towards a picture of the outcome. Dr. Murray: I think this is a particularly useful observation for the finish. All of us are properly concerned that in the application and use of options and futures, people will only get readings of what has happened. This will not really give them the information that they think they're getting. If that is true, and I think that we see ample opportunity for those kinds of misperceptions, it means that people are going to make the wrong decisions, or at least decisions that they did not plan to make, based on misleading information. I want to thank all of our participants today for their contributions. I know I speak for of all of you in expressing appreciation for the way they took us on a tour of some of the new developments which are in process, and which in the future will have a basic and material impact on our thinking about the management of securities.

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Glossary Arbitrage: Any activity which attempts to buy a relatively underpriced item and sell a relatively overpriced relationship. At the Money:, The striking price of an option equals the market price of the underlying stock (or index). Basis: The difference between the price of a cash commodity (actual stock index) and the price of a specific futures contract for that commodity (index). Call Option: The right (but not the obligation) to buy a particular security at a specified price known as the strike price or exercise price. Conversion: A transaction in which an investor (usually a member firm in equities or a bond dealer) buys the underlying security, and sells a call; from the viewpoint of the market, a put disappears and is replaced by a call. Covered Call Writer or Seller: A call seller (writer) who is long a future on the calls he sells. By being long the index he is protected from any loss by an increase in the price of the index during the duration of the call. Deliverable Security: A security that may be delivered when a put or call is experienced also known as the underlying security. Delivery Month: A term used to designate the month in which the futures contract expires. Ex-dividend: The date on which a purchaser of a stock does not receive a divend. A call owner who exercises the day before a stock goes ex-dividend is entitled to the stock and the dividend, notwithstanding that the call writer will learn of the assignment only after the stock has gone ex-dividend. Exercise: To do what a stock option gives one the right to do; i.e., to purchase stock for the strike price in the case of a call and to sell stock for the strike price in the case of a put. Exercise Price: The price at which the buyer of a call can purchase the underlying stock during the life of the call, and the price at which the buyer of a put can sell the underlying stock during the life of the put. Also called strike price.

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Hedge: To reduce the risk of loss from an investment position by making approximately offsetting transations that will largely eliminate one or more types of risks. In the Money: A call (put) would be in the money if the current price of the stock (or index) is above (below) the strike price of the call. long: Denotes ownership of a security, including options; also refers to the owner of an option. Mark to the Market: The process of adjusting a margin account each day to the current prices of the underlying securities. Out of the Money: A call (put) is out of the money when its strike price is above (below) the current price of the stock (or index). Premium: The market price of an option.

Put Option: The right (but not the obligation) to sell a particular security at a specified price known as the strike price or exercise price. (See American Option and European Option.) Reverse Conversion: A transaction that results in a call being removed from the market with a put taking its place. Rolling Over: Sutstituting an option with a different expiration date and/or a different striking price for a previously established option position. Rolling over usually involves substituting an option with a more distant expiration date for the existing option position. The process is called rolling up when an option with a higher striking price is substituted and rolling down when an option with a higher striking price is substituted for the previous option position. Short: As a verb, means to engage in an Open Sale; as a noun, refers to one who has written an option. Straddle: A position in one put option and one call having the same strike price and expiration date. A long straddle involves a long position in both the puts and calls. A short straddle involves a sale of both the puts and calls. Strike Price: The price at which an exercise transaction takes place; the strike may be adjusted for options that allow delivery of one of a group of securities, and is sometimes quoted in terms of a strike yield. Also known as the Exercise Price. Synthetic Can: Results from the purchase of a put plus the purchase of a future, creating a call. Synthetic Put: The purchase of a call and the sale of the future, creating a put. Underlying Security: A security that can be delivered when a put or call is exercised; may also refer to the nominal security on which strike prices are based when there are multiple deliverable securities, as in GNMA options. Writer: An investor who is short an option contract; also known as the option seller.

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