Forward Contracts and Futures
A financial basket contains a fixed portfolio of financial objects, such as bonds, and options warrant swaps. Although baskets have many financial applications beyond the stock market, this article focuses on swaps and options involving baskets of shares. Part I, this week, emphasizes structures, and applications.
The Size of the Market The market for derivative securities has become very large in recent years. The economic function of swaps and derivatives is to transfer risk from those who have it but who do not want to bear it to those who are willing to bear it for a fee. In this respect the derivatives market is much the same as the insurance industry. For example, a put option is insurance against the price of a stock falling. And, like the insurance industry, both the insuree and insurer are better off as a result of the transaction.
Future pieces will discus risk management issues, and outline the theory of pricing equity basket derivatives. A basket offers a combination of two contradictory benefits: focus on an investment style or sector, and diversification across the spectrum of stocks in the sector.
Institutional investors can also buy equity baskets and derivatives made-to-order.
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Mutual funds issue and retire shares to meet investor demand. Some mutual funds are equity baskets. Some aren't.
EQUITY BASKET SWAPS AND OPTIONS: PART I
Index funds keep the investment proportions nearly the same as the weights in the index, and these change glacially. An individual investor can buy a basket approximately by buying such a fund.
However, the typical fund manager changes his portfolio composition actively. Such a fund is not a basket. By definition, an ETF is an investment fund--other than a closed-end fund--that trades on an exchange. SPDRs are claims on the basket of U.
Qubes track the Nasdaq index. An equity basket by definition is not actively managed--buying an ETF where management can actively change stocks in the portfolio would not be a way to buy an equity basket.
Transaction costs on an equity basket swap can be about the same as for the corresponding options warrant swaps transaction, if the dealer does the cash trade to hedge his exposure. However, on rare occasions a customer can do better, if he accommodates the dealer's desire to trade out of an exposure.
Other Derivative Securities
A basket swap may lack liquidity, because only the dealer can tear up the original agreement. Doing an offsetting transaction with another dealer leaves the customer exposed to the counterparty credit risk of two dealers. Equity index futures contracts tend to be more liquid than OTC products, with smaller transactions costs.
- Share16 What it is: An option is a financial contract that gives an investor the right, but not the obligation, to either buy or sell an asset at a pre-determined price known as the strike price by a specified date known as the expiration date.
- Structure and features[ edit ] Warrants have similar characteristics to that of other equity derivatives, such as options, for instance: Exercising: A warrant is exercised when the holder informs the issuer their intention to purchase the shares underlying the warrant.
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However, they must compete with the variety of OTC products. For example, an equity basket call option provides the right, but not the obligation, to buy the equity basket options warrant swaps the strike price on the expiration date.
Some basket options have physical delivery, while others settle in cash for the difference between the strike price and the market value of the basket. Using an underlying basket, rather than just underlying mutual fund or closed-end fund shares, is significant.
While the volatility of a basket may change over time, complicating the job of pricing a basket option, at least the composition of an underlying basket is not subject to moral hazard. For example, the manager of a diversified stock fund might buy an option of his fund's shares, sell off his more sedate stocks, and invest the proceeds in volatile and highly correlated Internet stocks.
This would boost his portfolio's volatility and the value of the options. Obviously, OTC option dealers aren't going to participate in that game. Equity basket options have selling points that baskets and swaps don't. For example: a An investor bullish on a sector but wanting downside protection may favor a call option on a basket of shares from that sector.
Unfortunately, transaction costs can be prohibitively large, particularly when it comes to closing out an OTC option position. A basket call warrant is a covered warrant if the issuer owns the underlying basket. An issuer of covered warrants typically lists its covered warrants on an exchange.
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This makes the product available to investors who cannot buy OTC products and increases the warrant's liquidity. For example, a structured note's coupon may consist of a fixed component that is twice the market coupon and a floating component that is essentially a short equity basket call option.
Such a structured note may make it possible for an investor to use a "fixed-income" instrument to profit--or lose out--from an opinion about an equity sector.