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Is Equity Protection Worth It?

A lot of institutional investors are convinced the U.S. stock market has peaked and is ready for a decent-sized correction. But volatility is high and put protection doesn't come cheap. Moreover, many investors who purchased put protection during the past few years have had regrets-and some have vowed never to hedge their downside again. What's a worried but cost-conscious institutional investor to do?

We asked some leading dealers to discuss their ideas. They've suggested a wide range of strategies: at-the-money put spreads, zero-cost collars, basket hedges, outperformance options of various kinds, and other kinds of puts with fancy knockouts. There's some disagreement about whether the cost of put protection is "outrageously high," and many dealers don't even recommend hedging at all. One thing is certain: although investors are afraid of a correction, few seem to be doing anything about it.

Dave Duebendorfer
Managing director and head of global equity derivatives, Deutsche Morgan Grenfell, New York

The significant gains experienced in the major U.S. indices during the second halves of 1995 and 1996 have definitely led to a reassessment by clients who have historically entered into year-end collar transactions, with many deciding not to repeat the strategy. In addition, we have noted a clear reduction in the number of clients buying over-the-counter puts in the second half of 1996 vis-á-vis previous years.

The combination of fewer out-of-the-money put buyers and call sellers can be seen in the six-month skew, or volatility difference between the 95-percent strike and 105-percent strike. This currently stands at 3.00 points, down from 3.40 points as of late 1995 and 1996. Put protection, however, is more costly, because of the higher levels of volatility. For example, the current price for a one-year at-the-money put on the S&P 500 would be approximately 5.0 percent (17 percent implied volatility), as compared with 4.75 percent (16.7 percent implied volatility) as of the end of the third quarter of 1996.

Despite the lower skew levels, one potential structure that might appeal to investors who view any potential market correction as being relatively limited would be to buy an at-the-money 95-percent put spread for one year at a premium coast of 1.6 percent. Assuming a current cash spot level of 786, this would afford an investor protection on the S&P 500 index to around the 746 level for a lower premium outlay than a regular put option, although the put spread would not protect against a general market meltdown.

Another strategy for investors who seek greater downside protection but would still like to reduce the premium outlay would be to buy a 90 percent out-of-the-money put and sell the 110 percent/119 percent call spread for zero premium. This is a modification of a traditional collar, in which the investor gives up the upside on the market between a 10 percent and a 19 percent gain, but neutralizes the short 110 percent call position with the long call position at 119 percent of spot.

In theory, it could be assumed that the higher market volatilities would make barrier put options an attractive alternative for reducing put protection premiums, but we have thus far seen a limited amount of these inquiries. This is primarily because the premium savings of a barrier option are minimal when compared with a straight put option. For example, a one-year at-the-money European put on the S&P 500 that knocks out at 904 (15 percent out-of-the-money strike) would cost 4.65 percent, as compared with 5.00 percent for the straight at-the-money put.

Steve Kim
Equity derivatives analyst, Merrill Lynch & Co.

Currently, the view of the Merrill Lynch quantitative group on the market is bullish. We are recommending that investors not hedge their equity exposure but rather stay fully invested.

According to head quantitative analyst Richard Bernstein, there is significant pessimism among investors. For example, his "sell side indicator," which measures the stock/bond/cash allocation of Wall Street strategists, shows a very low allocation level to equities. In the past, this sort of pessimism led to significant upside in the market. In fact, our belief is that very few tactical asset allocators are over-weighed in equities currently.

We also see the inflows into mutual funds continuing, which should bolster the market. As the market rises, the idle cash in institutional accounts is likely to flow back into the market as institutional managers have low tolerance for pain. People have argued that valuation is a key point of concern, yet Rich's work indicates that the market is moderately overvalued, but not to a degree that it would exhibit significant risk.

Given the bullish scenario, we do not recommend hedging. Of course, there may be short-term declines, but investors, particularly strategic ones, should not concern themselves with short-term blips. Trying to hedge this sort of blip would be costly, and ultimately would reduce performance.

If an investor has a strongly negative conviction on the market, he or she could do a full or partial hedge using futures. Futures are quite liquid, so investors can hedge sizable positions. In addition, the calendar spread on the S&P 500 has been trading slightly expensive to fair value, so a short futures position can be rolled advantageously.

Also, implied volatility is quite high at the moment, a condition that accentuates the cost of hedging.

Since the elections last November, there has been a rising demand for long volatility. As a result, market-makers went into year-end with short gamma positions, which resulted in rising implied volatility, even in the face of a rising market. This situation has carried into 1997. Investors seem to be jittery, but the cost of downside protection is not cheap at this point, so many are holding back on hedging. Another key factor is that many institutional managers these days are judged on relative performance, so put hedging or timing markets is less of a concern for them.

Our belief is that, through this bull cycle, investors have become conditioned not to hedge if possible. Institutional investors might take opportunistic option positions-selling volatility when it spikes, for example; however, they are well aware of the consequences of rolling long protective put option positions through time.

Given the significantly negative skew in implied volatility, which means that lower strike options have higher implied volatility than higher strike ones, investors who are bearish might put on a put spread as an overlay to their underlying position. For example, an investor might buy an at-the-money put and sell a 5 percent out-of-the-money put. By taking on this position, the investor would be taking advantage of the negative skew of implied volatility. The overall cost of this position would be less than buying a put; however, this position would protect the investor only down to 5 percent (or where the lower strike is set).

Another position is a collar, in which the investor would sell an out-of-the-money call to finance an out-of-the-money put. This would create a position of limited upside and downside equity exposure (payoff is like a bullish call spread). However, investors need to note that they are selling options at low levels of implied volatility (higher strike) and buying at high levels of implied volatility (lower strike), which creates an asymmetric payoff with more downside than upside.

Susan Webb
Managing director and head of institutional investing, CIBC

We continue to see strong interest among our client base in hedging a portion, if not all, of their U.S. equity positions. So far this year we have executed a number of different types of hedges: collars (client sells calls and buys puts), various strike puts, put spreads, basket hedges, compound and installment puts, and puts that knock-out on various secondary underlyings. These secondary underlyings have included commodity futures, currency levels and different interest rate levels. The basic goal of all these structures is for clients to combine their views to effectively and efficiently reduce the cost of hedging their U.S. equity portfolio.

Corporate pension funds seem reluctant to utilize hedges. We talk on a regular basis to about 50 corporate pension funds, mostly in-house managed, who have utilized hedging strategies to varying degrees over the past few years. They now are concerned that they paid premium for hedging strategies throughout 1995 and 1996 that were never utilized. They are reluctant to return to their board and ask for permission to replace those hedges. However, given this past month's performance in the U.S. stock market with its dramatic rise and quick readjustment, we have seen a renewed interest in hedges.

There are quite a few strategies that we are actively recommending to cut the cost of buying put protection. Given our expectations for the U.S. market, I don't see current volatility levels as outrageously high. We anticipate a choppy market and don't foresee a return to 15 volatility (implied) on puts within the year, so the absolute level of put volatility should not be a deterrent in buying protection. Selling out-of-the-money calls (in the 8 percent to 12 percent range) but 3 month maturity, timed with market upswings and rolled over the year, can significantly reduce the cost of the protection strategy. We would also suggest buying either knock-in puts timed with market moves or slightly out-of-the-money puts (2.5 percent to 10 percent). Any further out of the money and the skew will affect the price too adversely.

In weighing the costs versus the benefits of various strategies, clients cannot hedge their portfolios without either reducing return (paying premium or giving up upside) or taking on risk. The knock-out put on secondary underlyings employs the latter strategy. For example, the client can buy an at-the-money put on the S&P that knocks out if the yen appreciates against the barrier. Depending on where the barrier is set, the put can be reduced by more than 35 percent. This strategy can also work well with the JGB or the Deutsche mark/dollar.

Clients who have a specific view can utilize out-performance option hedges, or focus on selling calls on stocks they feel confident they can give up the upside on. We strongly recommend using the S&P as the index of choice rather than the Russell 200, or NASDAQ. The liquidity and size limitations of the latter two are too significant.

In general, we believe that 1997 is a good year for prudent investors to hedge at least a portion of their portfolio.

Jonathan Sandleman
Managing director of global equity derivatives, Salomon Bros.

There are several different strategies people can use to protect against a drop in the S&P, depending on the dialogue they are having with the customer. They can sell futures, buy puts or do swaps against their positions, to name a few. They can take either a macro view, expressed through the S&P, or an individual view and sell individual options against their positions to monetize positions, taking some premium in to get some downside protection. If an individual loves his or her portfolio, thinks it would outperform the market-a mid-cap portfolio, a small-cap portfolio, an S&P, a large-cap portfolio-they can choose one of those indicies to hedge out, saying "I know I'll outperform the market, but I don't know what the market is going to do."

The more we can bring to customers to help them understand what exactly they own, using various factor models, the better we can hedge out if they have large implicit interest rate exposure (a high correlation to the direction of interest rates). If they generally feel they are outperforming, they can sell the market against the portfolio. Sometimes the best trade is simply selling a slice of stocks. It doesn't always have to end up being a derivatives solution. Customers can do a programmed trade with us on either an agency or competitive bid situation.

Puts are very expensive at this point. Volatilities are trading at 17 implied. This is the longest period of time in many years in which premiums have stayed as high as they are now. They usually spike to this level and come down, but 30-day volatility is trading at 12. Last December we saw as large a premium as we have ever seen. Premiums are historically high versus realized. Yet some people are buying puts for protection.

Another phenomenon I have witnessed is a proliferation of huge S&P overwriters in this marketplace-a group of managers that only get the overwrite money. A pension fund manager says "You overwrite my portfolio, but don't manage any of my money, and I'll give my active money to these 10 other people, but you do the overlay strategy based on these other positions that people have." Those people for the most part are out of the marketplace. That's the biggest technical change I see in 1997. Those overwriters are no longer in business, because selling S&Ps has been a bad business.

With no natural seller and people hedging the marketplace, premiums inevitably go up. That allows people who trade in volatility to take advantage of those spreads. But they are selling them rather than buying them. That's what hedge funds will be doing more of in 1997. They'll look at the difference between realized and implieds and determine that that's a very good trade right now. Traders who sell June volatility against what we have seen in the last 30 days make an assumption that volatility is not going to be 17, which would require a move of about 1.5 percent or so every day until June. You certainly can have spikes, but on average every day has to be that kind of move, and people are willing to make that bet.

People are concerned with the market-the market is up 6 percent in a month, 500 Dow points in a month. We watched S&Ps in a week go from 767 to 799 and then down 16 points at the low. There is nervousness. Everyone feels like they have to be in because they are under-performing, but on the other hand, it's hard to believe. There is concern. Interest rates are going higher, and the market hasn't reacted.

Ramesh Ramanathan
Managing director of structured equity products, Citibank

When considering buying S&P protection, investors should evaluate their need for preservation of capital, market view and investment horizon. For example, an overfunded pension plan may view capital preservation as the ERISA full funding limit and thus structure hedges around contribution determination dates. Investors must fully evaluate the relationship between the S&P and the hedged assets. The relationship is critical if the investor chooses to fund protection by selling off appreciation in the index. Popular strategies such as zero-cost collars depend on a strong correlation between the hedged assets and the S&P.

There has been interest in standard zero-cost collars or collar/call spreads with some interest in call overwriting. Most pension plans will match tenors to the plan-funding cycle, which usually coincides with year end.

The attitude toward purchasing puts or other more structured alternatives is a function of the underlying motivation for the original transaction. Investors and speculators who expected the market to have the much-anticipated correction have obviously been wrong, and hence have a greater hesitation to purchase again. However, those investors who purchased protection as part of a broad risk-management strategy continue to show interest in hedge ideas.

Our approach at Citibank is to identify the specific investment considerations of a client before recommending a strategy. We are wary of an over indulgence in unnecessary financial engineering that does little for the client. We also try to ensure transparency in the structuring and pricing of any solution, so clients are comfortable that they aren't getting a black box. An example of a useful strategy is up-and-out puts, where the put knocks out in an up market. The strategy is similar to a zero-cost collar in that the investor sells volatility to fund protection. However, the investor does not risk giving up significant appreciation in the index.

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