Derivative instruments assist investors in managing their portfolios like no other financial security due to their flexibility. Investors can use derivatives to either hedge current long positions in their portfolios, as they assume their long positions will experience short-term price declines. They can also use derivative instruments to speculate on certain price movements and make high profits from that owing the leverage derivatives offer (Hull 2002:8-10).
With other strategies investors want to profit from the premiums obtained from other investors when markets move only slightly up or down. The most common strategies applied by investors are protective puts, covered calls, straddles, strangles, as well as spreads and collars (Bodie et al. 2009:682-687). A summary of the purpose and actions necessary to create these positions are shown in Table 2.15.
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TABLE 2.15: Purpose of investment strategies using options
Strategy Purpose of the strategy Investment actions
Protective put
To hedge the underlying long positions such as shares or bonds against price depreciations, thus return losses. Used in volatile markets as investors do not want to bear the risk of losing large sums or all their money.
Combine the symmetric pay-out profile of a share with the asymmetric pay-out profile of an option, in this case a put option long.
Covered call
To increase profits in times of very little market movements and dividend payments by obtaining premiums of the options sold short.
Combine the symmetric pay-out profile of a share with the asymmetric pay-out profile of an option, in this case a call option short.
Straddle
To participate in uncertain market movements. Used to increase profits in times of increasing volatility and uncertainty regarding the direction in which markets will move (straddle long). Can also be used in markets with very low volatility and with little movement. In which case options are sold short and investors benefit from option premiums received (straddle short).
Combine the asymmetric pay-out profile of options. In the case of a straddle long combine the same amount of call options long and put options long with the same strike price and expiration dates. In case of a straddle short, sell the same amount of call options and put options with the same strike price and expiration dates short.
Strangle
To participate in uncertain market movements. Used to increase profits in times of increasing volatility and uncertainty regarding the direction in which markets will move (strangle long). Can also be used in markets with very low volatility and with little movements. In that case options are sold short and investors benefit from option premiums received (strangle short).
Combine the asymmetric pay-out profile of options. In the case of a strangle long combine the same amount of call options long and put options long with the same expiration dates but with different strike prices. In case of a strangle short, sell the same amount of call options and put options with the expiration dates but different strike prices short.
Spread/Collar
To benefit from market movements in a specific price range. Used to off-set costs experienced when buying options by selling options short.
Combine the asymmetric pay-out profile of options. In case of a bull spread investors buy a call option long with a lower strike price than the call option they sell short. With a bear spread investors sell a put option with the lower strike price short and buy the put option long with the higher strike price.
Source: Adapted from Bloss et al. (2008:60-64); Hirt & Block (2008:378) and Bossu & Henrotte (2006:59)
70 Besides futures and options contracts which were discussed in detail in Sections 2.3.1 and 2.3.3 in this chapter, investors can make use of swaps. A discussion on what swaps are and how they can be used by investors will be explained in the following section.
2.3.5 Swaps
Swaps, which were introduced in 1981, are a significant component of the world wide derivatives markets. They are similar to forward rate agreements, with the difference that the two parties entering into a swap, exchange cash-flows not only once, but several times on specific future dates (Hirt & Block 2008:407; Firer et al. 2004:713).
The major characteristics of swaps are that their pay-out profile is, like the ones of futures, symmetric. Thus, it is similar for both parties entering into the swap. Swaps are, like forward rate agreements, only traded over-the-counter and their volumes are usually large. Swaps, unlike forward rate agreements, options or futures are long- term agreements. As no premium has to be paid the costs of swaps are low in general (Maier 2004:323).
Swap dealers play an important role in swap agreements. Swaps are, unlike futures not standardised, they are not traded on exchanges and their transparency is very limited. It is therefore difficult for parties to find suitable counterparties to enter into an agreement with. The swap dealer (the intermediary), usually a merchant or investment bank, brings the two parties together, who enter into a swap (Firer et al. 2004:714).
The swap dealer’s main work besides finding suitable counterparties is funneling payments between the two parties (Bodie et al. 2009:806). Companies do not need a swap dealer should they find a suitable counterpart in the market themselves. This would decrease costs, as swap dealers make money from bid-ask spreads.
Companies enter into swap agreements for different reasons, but the main reasons are their interest rate expectations or their financing needs that change (Maier 2004:325).
71 There are basically two major forms of swaps available, namely foreign exchange and interest rate swaps. Interest rate and currency swaps are of interest to financial institutions and corporate companies who deal in highly volatile exchange and interest rates, such as is the case in South Africa. With foreign exchange swaps two parties exchange currencies, such as US-Dollar for Rand or vice versa on several future dates. Interest rate swaps, on the other hand, allow investors to swap series of cash-flows emanating from interest payments. Usually parties who agree on an interest rate swap exchange a variable payment with a fixed payment and vice versa (Bodie et al. 2009:804).
As several examples in Sections 2.3.2 and 2.3.4 of this chapter illustrate, options and futures are predominantly used for short-term hedging and trading purposes. Swaps, on the other hand, help investors to reduce their interest payments and to adapt their financing needs for long-term periods. In countries, such as South Africa, with volatile interest rates and exchanges rates, swaps are attractive financial instruments to financial and corporate institutions in order to structure their payments and secure prices.
Other derivative instruments that are often used in South Africa and which will be explained in more detail in the next section are warrants.
2.3.6 Warrants
Warrants are similar to option contracts. They give the buyer the right, or option to buy a certain number of a company’s shares which offers the warrants. Unlike options, which usually have maturities of three to six months, warrants have a much longer time to maturity; up to ten or more years. Warrants are often issued along with debt instruments, such as bonds in order to make the bond offer more attractive to investors. Warrants are, like ordinary options available as puts and calls (Hirt & Block 2008:351; Mayo 2008:708).
Most of the warrants issued today are detachable, which means that once the bond which the warrants are attached to is sold, the warrants can be traded individually. Investors will exercise their warrants, if they are long call warrants, only when the
72 current share price trades over the strike price, thus they can make profit (Bodie et al. 2009:696).
Investors will also execute their options should the company the warrant is issued on declare a high or an increase in dividends, making it unlikely that the share price will reach the strike price. In that case, investors execute their warrants, buy the shares and obtain the dividend, which they would not have received by only holding the warrants. A third reason why warrant holders would want to execute their warrants early is because some warrants are issued with stepped-up exercise prices. Should, for example, investors own warrants with a strike price of R35 and the stepped-up price is R40 and the current share price is R37, investors would execute their warrants now before the stepped-up price takes effect, thus reducing the value of their warrants (Brigham & Ehrhardt 2005:720).
Another common derivative instrument, a structured note, will be explained in more detail in the following section.