Zero-Premium Collar Description - University of Colorado Boulder

Zero-Premium Collar Description - University of Colorado Boulder

Concentrated Position
Risk Management
Tuesday, April 18, 2006
University of Colorado at Boulder
Finance 4040 – Derivatives
Jim Dull, CFA
Financial Advisor
Jeremy Shevlin, CFP
Financial Advisor
1
Table of Contents
I.
Introduction to Crestone Capital Advisors LLC
II.
Concentrated Position Risk Management
III.
Zero-Premium Collar Example
IV.
Variable Pre-Paid Forward Example
V.
OTC vs. Exchange-Traded Options
VI.
Hedging Constraints
VII.
Derivatives Exchanges
VIII. Question & Answer Session
2
I. Introduction to Crestone Capital Advisors LLC
• Crestone Capital Advisors LLC (“Crestone”), based in
Boulder, Colorado, is an independent wealth management
firm for high net worth individuals, families, and
foundations.
• Our services include investment management,
concentrated position risk management, estate and
philanthropic planning, and income tax planning and
reporting.
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II. Concentrated Position Risk Management
Reasons to Hedge:
•
•
•
•
4
Preserve / protect wealth
Provide liquidity for diversification
Limit equity risk exposure
Defer capital gains taxes
II. Concentrated Position Risk Management (cont’d)
Concentrated Equity Position
Benefits
Sale of Position
Short vs. Box
Sell Calls
Buy Puts
Collar
Pre-paid Forward
Generates
Cash Flow
Eliminates
Downside Risk
Generates
Cash Flow
No Ceiling on
Upside Exposure
Can be Zero
Cost
Significant
Liquidity Generated
Eliminates
Downside Risk
No Tax Event
(Until Earlier of
Short Cover or 1/31
Next Calendar Year)
No Tax Event
Until Maturity
No Tax Event
Until Maturity
No Tax Event
Until Maturity
No Tax Event
Until Maturity
Provides Floor
on Stock Price
Provides Floor
on Stock Price
Provides Floor
on Stock Price
Potentially
Significant Up-front
Cost
Ceiling on
Upside Opportunity
Ceiling on
Upside Opportunity
Can Generate Cash
Flow Via Margin Loan
(up to 95%)
Considerations
Recognizes
Capital Gain
Eliminates Upside
Opportunity
Creates a Ceiling on
Upside Opportunity
(Until Call Expires)
Eliminates Upside
Opportunity
Protected Stock Position Facilitates
Collateralized Lending Arrangement
Monetize Puts
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Monetize Collar
III. Zero-Premium Collar Example
Zero-Premium Collar Description
• Most common exchange-traded hedging/
monetization transaction
• Standardized contracts
• American-style options
• Tax deferral strategy
• Creates downside floor and allows for upside
participation
• Possible up-front liquidity via margin loan
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III. Zero-Premium Collar Example (cont’d)
ABC, Inc. – 5 Year Price Chart
A
B
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III. Zero-Premium Collar Example (cont’d)
A
In early 2002, an investor that owns 100,000 shares of ABC stock executes 1,000 Jan 2003
$20 put, $30 call collars for even money (covering all 100,000 ABC shares) when ABC stock
is trading for $25/share.
Short Call
Long Put
Upside
Capped
At maturity, if
the final price
of ABC stock is
$30 or lower,
the call expires
without value.
Investor does not
participate in
upside stock price
appreciation above
$30.
Investor retains first
$5 of stock price
appreciation.
Downside
Exposed
Investor has no
downside
protection other
than premium
received.
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Upside
Participation
Call Strike = $30
Initial Price = $25
of ABC stock
Investor retains
100% of upside
stock price
appreciation less
premium paid.
Investor exposed to
first $5 of stock price
depreciation.
Put Strike = $20
Downside
Protected
Investor has
downside
protection at $20
and below.
At maturity, if
the final price
of ABC stock is
$20 or higher,
the put expires
without value.
III. Zero-Premium Collar Example (cont’d)
Zero-Premium
Collar
Upside Capped
Investor does not
participate in upside
stock price
appreciation above
$30.
Call Strike = $30
Investor retains first $5
of stock price
appreciation…
Initial Price = $25
of ABC stock
Andisisexposed
exposedtotofirst
first
And
$5 ofof
stock
price
$(y-x)
depreciation.
depreciation.
Put Strike = $20
Downside
Protected
Investor has
downside protection
at $20 and below.
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At maturity, if the final
price of ABC stock is at
or between $20 and $30,
both the call and put
options expire without
value.
III. Zero-Premium Collar Example (cont’d)
ABC, Inc. – 5 Year Price Chart
A
B
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III. Zero-Premium Collar Example (cont’d)
B
In September 2002, the same investor exits 1,000 Jan 2003 $20 put, $30 call collars for
$10 per contract (covering 100,000 ABC shares) when ABC stock is trading for $10/share
and retains his 100,000 long ABC shares.
Put Sale
Intrinsic value = $10.00
Time Value = $0.00
Call Buy
Intrinsic value = $0.00
Time Value = $0.05
Total Gain on Hedge:
1,000 contracts
x $9.95/contract
x 100 multiplier
=
$995,000
* Note that the investor retained his long stock position but incurred an unrealized loss
of $1,500,000
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IV. Variable Pre-Paid Forward Example
Variable Pre-Paid Forward Description
• Most common OTC hedging/monetization
transaction
• Fully customizable contracts
• Most likely European-style options
• Tax deferral strategy
• Creates downside floor and allows for upside
participation
• Significant up-front liquidity inherent in structure
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IV. Variable Pre-Paid Forward Example (cont’d)
In early 2002, an investor that owns 100,000 shares of ABC stock enters into a 3 year VPF
contract when ABC stock is trading for $25/share.
The VPF is structured with a minimum price/share value of 100% ($25/share), maximum
price/share value of 120% ($30/share), and a cash advance of 84% ($21/share).
Trade Date
Maturity
Three Years
Upper Strike = $30
Investor retains up to $5 of appreciation
Lower Strike = $25
Advance = $21
(Investor receives $2.1M upfront)
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Investor is fully
protected below
$25, less implied
financing costs
IV. Variable Pre-Paid Forward Example (cont’d)
ABC, Inc. – 5 Year Price Chart
A
B
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IV. Variable Pre-Paid Forward Example (cont’d)
In early 2005, the price of ABC is $12 and the investor settles the trade
by delivering 100,000 shares of ABC stock to the counterparty.
Had the investor remained un-hedged over the 3 year period and held
the long position, she would have lost the benefit of investing the
$2.1M cash advance and would now only have $1.2M worth of ABC
stock.
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V. OTC vs. Exchange-Traded Options
OTC
•
•
•
•
•
•
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Customized
Counterparty risk
More expensive
Largely unregulated
Privately negotiated
Less liquid
Exchange-Traded
•
•
•
•
•
•
Standardized
No counterparty risk
Less expensive
Regulated
Publicly traded
More liquid
VI. Hedging Constraints
Regulatory
•
•
•
•
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Rule 144
Section 16(b)
Margin requirements
Trading windows
Practical/Operational
•
•
•
•
Liquidity
Marginability of shares
Float (borrow)
Behavioral constraints
VII. Derivatives Exchanges
Futures Exchanges:
• Chicago Mercantile Exchange
(CME)
• Chicago Board of Trade (CBOT)
• New York Mercantile Exchange
(NYMEX)
Equity Option Exchanges:
• Chicago Board Options
Exchange (CBOE)
• American Stock and Options
Exchange (AMEX)
• Philadelphia Stock Exchange
(PHLX)
• Boston Options Exchange
(BOX)
• International Securities
Exchange (ISE)
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VIII. Question & Answer Session
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