You are on page 1of 55

Derivatives and Structured Products

Autumn Derivatives Seminar


Session 1: Basic Structures and Markets

Ken S hoji
September 17th, 1996
Agenda .,

Forward contracts

Options
- Calls
- .Puts
- Combinations

Swaps
- Interest rate swaps
- Currency swaps
- Total returnswaps

Structured notes
Derivative markets
Derivatives

Derivatives are contiactual agreements


- Forwards and futures are obligations
'

- Options are contingent obligations

Derivatives can take many "forms"

Derivative contracts do not generally confer on the holder rights and


values associated with direct, physical ownership of the asset, such as
dividends, coupons or voting rights .
Forward contracts
-- Anagreement to-buy or .sell.stock at .a
specific strike price on a specific future
date

Fonvards aliow clients to take long or


short positions
Fonvards allow clients to lock in a price
today
'. .
Forwards can be cash settled (gains or
losses paid in cash)

Ali futures contracts are a form of


forward .'

p-~--F~ Stock
Call option
A Call option gives the owner the
right, but not theobligation, to buy
stock at n specific price on or berorc .
the expiry date . .

'Call buyer pays an upfront prc~nium

------_-d

Premium $3
Option terms and conditions

Option Seller: Morgan Guari~ntyTrust Cotnpany of New York, London


Option: Call
Underlying Asset: Common siock of Microsort ("MSIT")
Number of Shares: 100,000 shares
Trade Date: September 17, 1996
Payment Date: September 19. 1996 (Trade + 2 days)
Expiry Date: Septembcr 17, 1997 ( l year)
Settlement Date: Se$tember 20, 1997 (Expiry + 3 days)
Settlemeit: "Cash" (could be "Physical")
- .

. Option Style: "European" or "American"


Strike Price:
- . $125.25 ("~t-the-money,in-the-money, o r out-o f-the-moheyw relative to the
"Spot" price on the Trade Date)

$15.97 ( 1 2.75% of the spot price)


.' Put Option Buy Put at $10 strike &ice, $3 premium:
At Expiration

A Put option givesthe owner the right, Price Result


but not the obligation, to sell stock i t a
specific price on or before the expiry $10 Put expires wonhlcss Slack $LO - Option $3
date No option pnyment . Net = $7 .

Put buyer pays an upfront plrl11i~1111 5 15 I'ut cxpircs worthless stock'$IS- Option $3
'NO option payment Net = $12
Puts provide dbwnsidc price protection
$5 Put exercised Stock $5 - Option $3
JPMmllkespayment +Payment$5
of $5 Net = $7

Premium $3
Payoff profiles

Price

P&L Short Put Short Call

Price
Option spreads
Buy OTC Call spread at $10 strike, $17 cap, net $2

Different options can be combined to


produce a specific risk profile Portfolio P&L

In the exchange listed markets each ~ $ 1 0 Call expires worthless - Option $2


option is a discrete, separatc No option payment
,transaction
$15 JPM makes payment Payment $5 - Option $2
In the over-the-counter market options
can be combined into n single contract

.........................
Call ,
Prcmium $3

; .. i
$12 .
-.
$17
$5 $10 $15 Price
Collar
Collar with $7-$15 range, no premium ('cashlk"):
A client buys a Put and sells n Cnll with
the same expiry date

At maturity: $ 7 - 1 5 Nocollarpayments Stwk$7-15

- I f share price is lower than the Put >$15 Client makes payment Stock >$I5
strike, JPM pays the difference
between Put strike and markct
price
- If share price is higher than thc JPM makes payment Stock <$7
Cnll strike, client pays thc
difference between market price
and Call strike
I f premiums net out the transaction is
described as a "cashless" collar

Pay mcnt
Swaps: Interest rate swaps
. .

',

A contract where counterparties


2 year swap on $100 against 6 month Libor:
periodically exchange fixed for ilonting -
rate interest flows Cash flows (client's nersnectivcl:

Cash flows are generally netted against


Rak ~~~ mslea
each other. There is no exchange of Libor 6% 8% 10% 6%
principal either initially o; at maturity
Floating -$3 -$4 -15 -$3
. Swaps involve credit exposure to Fixed W $4 $4 $4
counterparty
Net $i $0 -$I $I
The standard floating rate benchmark is
,Libor, but other indexes (Fed Funds, CP, L
PSA) are also available 1

6m Libor

Client Fixed 8%s.a.


Swaps: Currency swaps
A contract where counterparties 2 year swap on $100.6 month Libor against DM150 8 %
paiodicall y. exchange cash flows in s.a. fixed: ',

I
different currencies ~ash.ffowkenS
s s ?eW'ect iv&
I

Flows for the 2 "legs" of rhe swap may be


fixed or floating rate m < 2EL 3m9mmslea

I
US$ Libor 6% 8% 10% 6%
Cash flows are not netted against
eachother. There --exchange of principal US$ Floating A $100 -$3 -$4 -$S -6103-

DM Fixed .-DM150DM6 DM6 DM6 DM156

-
M Fixed 89Ls.a.
. Swaps: Total return.swaps
' Swaps can involve exchanges-of virtually
any type of cash flow'sor asset returns 2 year S&P500 TRI swap on $100 against 6 month Libor:

In "total rate of return" swaps the total


-
Date 9/96 9/97 3/98 9/98 + 9/98
return of an asset is exchanged for an
.interest flow

While interest flows are paid on an accrual


basis, index returns generally paid out Equity $0 $0 . $0 $20 -$I0
at maturity , -

, Interest -$3 -$4 . -$5 -%3 . 43


Total returns can be negative as well as
positive Net -$3 -$4 -$S $17 -$I 3

Swaps on fixed income, international .


equiiy or commodity ii~dexcsarc also
available

S&P500 TRI

Li bor
Structured Notes

1. Investor wants to buy a note linked


to the total return of the S&P500 TRI 3. Issucr enters into a S&P500 TRI
index. JPM finds an issuer or asks swap as the hedge for the note.
MGT Nassau. At maturity receives gain or pays
. loss. This is combined with deposit
rcdcmplion and paid to investor.

the S&P500 TRI


S&P500 TRI

Invcstor Issuer Libor


u
$100 Li bor

2. Issuer deposits proceeds into


a Libor deposit. Interest flows
offset liability in the swap.

I Alternatively it uses the cash


for investments or other purposes. I
' 0

. .
. . .
It.

3. EDG sells thc call option to MGT.


Sincc a call on $100 worth of thc
basket costs 1 1.4%. or $ 1 1.4, the $7.53

<
available buys 66% participati,on in the
appreciation of the basket ($7.53 151 1.4
The Derivatives Group launches an> . . = 66%). At maturity EDG pays any
MPD on the "European Corporate . appreciation to MGT Nassau. This is
Restructuring Basket". The 100% combined with the $100 guarantecd
principal protection version oifcrs 66Yo redemption amount.
parficipntion in the basket ups,idc.
,
Y
,

C ~ Ioption
I on
European Rcstrucluring Europcan stock
MPD bas kel

to the bank's funding dcsk. I n 18


months intercst at ~ibor-25bps.
produces the $100 guaranteed
;edernption which we have promised
the investor. Nassau buys the option
from EDG with tlw remaining $7.53.
Exchange versus over-the-counter markets
Exchange Over-the-counter

Products * , Listed contracts with + Structures limited on1y by


standardized specifications liquidity of underlying asset
Terms Strike pricesand maturities set Customized for each
by the Exchange transaction

Settlement Physical Physical or cash

Exercise .'
American (Random American or European, with
assignmen t of exerc,ise) negotiated exercise

Credit risk Options Clearing Corporation - Dealer


Liquidity , ,
Openoutcryauctionmarket *. Dealer
Derivative asset classes .

1 Commodity-
Swaps & . Foreign
Derivatives Fixed I Exchange Market
, , Derivatives
Income ~erivaives Derivatives
Dcrivativcs
..Currency
Interest rate .
.Brady bonds Energy
Precious meta
..
St~ks
Baskets
Equity indexes
..
Treasury
. Indexes
I .
,Interest rates
Currencies
Base metals
Agricultural
- . . I b

Derivatives Derivatives Dcrivatives - Der iva t ivcs


Plcasc kccp i n mind...

-This hooklct is intcndcd lo inrorn~you olprcducrs and scrviccs ,dr~ridhy T h i s n~alcri;tl-isno1 in~cnrfcdas nn ortcr or solicitation Tor thc purchasc
, ,
J -1'. Morgan. J.P. Mjrgan is thc mi~rkctingn:anc Ibr J.1'. Morgan & Cu. or s;llc or ;my li~~nncial Specific rcrcrcnccs arc for
instru~~~cnt.
'
Inuorporatcd and its subsidiwics worldwidc. Rclcrcnccs 1i1"J.P. Morgatt" illuslmlivc purpscs only. J.P. Morgan may hold a position or XI as
cnc'ornpass its w~rldwidcnclwork of subsidinrics, ir~uludingMorgan r~larkct111akcri a rhc linanciill instrumcn~sor markcts rclcvanl ro MPDs.
Guaran~yTrusl Cotnpany of New York. J.P. Morgan Sccuritics Inc. - , J.1'. Murgan nay cngagc i n l~cdgingor otllcr opcrations'in such mnrkcls
(JPMSI),and J.P. Morgan Invcstt~lcntM i m a g ~ ! c ~Inc.
l t J.1'. Morgan rclcvan! t o its MI'D cxposurcs.
Sccurilics Inc. JPMSI is a mcmhcr of thc Ncw York Slack ~~XC~I:III~L'. f!ic.,
thc Naiiuniil A<srxi;~tioai,fSccurilics Dcatcrs, Inu.. ;~ntltllc Seutirilics JI'MSf's ~,hligillionsr l l l t l thc sccuri~icssold, offcrcd, or rcconuncndcd
. . Invcstor Protcc~ion Carporation in thc Unitcd Sl;!tcs ;utd rlrc Socuri~ics;u~d h i JI'MSI ;ire rr,t dcpc;sils and ;Ire nol' ii\s"rccl by !hc Fcdcrul Dcposil
.. Futurcs Associalion in tllc Uni~cdKingdoal. l~~surnncc Corpc~ri~liu~l.
ihc 1:cdcrril Rcscrvc Donrd. or any olhcr
govcrnn~ct~lal ngcncy. JPMSI is 1101 ;Ibank and is a scparalc Icgal,cnlily
Opinions and csiimalcs oifcred constituk our judg~ncntand iirc suhjccr to from its hank and thrirt aTliliatcs. Thc ohligations OT JPMSl arc no1 ', ,
changc wirhout nolicc, us ari starcknts un linanciiil ~n;irkcttrends, which ' obligil~ionsof its bank or thrift arliliarcs (unlcss cxplicilly stalcd
arc baqcd on currcnt markcl condi~ions.Wc bclicvc rhc information olhcrwisc), and thcsc aCliliatcs arc no1 rcsponsiblc fo; xc'urilics sold.
. providcd hcrc is rcliablc, hul i f should not hc nssurncd to bc ciiliur ol'l'crcd,or rccoi~~~ncndcdby JPMSI.
. accurate or complclc. Past pcrrormancc i s not inclicntivt: of' futurc rcsulls.
Addi~ir,n;lliafo;rrla~ion is nvailnhlc on rcqucsl. Q J.P. Morgan & Co.
Thc vicws and straicgics dcscrihcd lnay not bc suirilhlc for a l l iuvcslors. It~corpr;r!cd1996. - ,
This prcscntatiqn i s not intcndcd lo provide, and should not hc rclicd ti11
for, accounting, Icgal. or tax advicc, or invcs~nrcntrcconilnc~~di~tions. Yr~u
should consult your tax-or lcgaf advisor'atwut l l ~ cissucs discussed hcrc. .
. .
Derivatives and Structured Products
Autumn Derivatives Seminar
Session 2: Essential Investment Strategies

Ken Shoji
September 24th 1996
Why use derivatives?

Leverage
Generating income '

- Swaps
- Selling Puts
- Selling Covered Calls
- Percs

Options in asset allocation


Total return swaps

Foreign exchange forwards


Leverage in options

, Options can often provide.higherleverage than can be obtained through


traditional forms of borrowing

"Risk free interest rate" i s Fnctorcd into option pricing

. . Retl~rncomparisons: Thy stock at $100 against buy ATM


Cali for $5 premium: -
Price 2u&r!JxBalL Cdl m m
$125 ,2596 25% $25 $20 400%

$120 20% 20% $20 $15 300%

Op~ian - . Stock
I
Leverage in swaps .

Swaps involve no cash upfront -


they'can provide 100% leverage
They do result in credit exposure
which must be managed
Total return swaps allow investors
-
Total
Return
on Asset
1
A
Client

Lihor +I00 bps


. .

touse our balance sheet and


financing capabiliiies ,
' JPM -
L i h r 25 bps
Lender
-
Swaps may have tax, accounting
and regulatory advantages over.
buying the asset directly
- . Asset $100

u Market
Monetizing positions using swaps

Swaps can be used to monetize the I . seil stock:


value of assets (generate cash) Stock -
without sacrificing economi,~ Client
exposure

Since swaps require no cash


. - investment returns are fully
2. Enter inlo swap:' -
leveraged
Srock total return.
~owev&,sinceswapsresultin , . .

.. credit exposure, we would generally


require collateral
. a Swaps may generate higher loan to
. asset ratios compared to,
.
3. Reprircltme stock nt matrrrily:
collateralized lending Stock -

Client
Monetizing positions using swaps

, Swaps can be used to convert capital I . Enter irtln swap:


returns into current income returns
pp+pF)
Stock total return

A client with a stock paying no


dividends who needs income can
convert equity returns into money
market or fixed income returns
2. Sell $rock nf matrrrity:

~Client' I J P M I
Selling put options
Sell Put at $10 strike price, $3 premium:

* . Why sell " ~ a k e dPuts"?


- Generate premium incomc $1 0 Put expires worthless Option $3
- Conviction that price will No option payment
not decline : >$I0 Put expires wonhless option $3'
No option payment
- "Happy ,to buy at that price"
if exercised ~ $ 1 0 Put exercised
Client makes payment - Payment ($10-Stock

Stock

$7

Premium $3

. .
I .

$15 Price
Selling call options

Why sell "Covered Calls"?


- Generate premium income
- Conviction that price will
not rise above strike price
-'"Happy to sell at that price"
if exercised -

pp J-J]
..
Stock

- ------ @ *'
I
-

Premium $2
Another M l s s s d Opportunity
Sometimes I t just doesnWcpay to hedge. O n
Frlday afterrroan. an l n s t l t u t l o n a l investor,
evldentiy concern d that an investment In
MFS communtcafions was nor moving,
declded to plck up a H t t l e income by setllng call
optlons on the stock. T h e rtek was the investor '
would mtss out on any rlss In tho stock. ?hat
was exactly what happen& when M F S eald it
had agreed to be acqulred by Worldcorn.
Floyd Norrls :Market Place. [ P6.1

I
'
THE NEW YrlRlC TIMES, TUESDAY. , A UGUST 27, 1996

Market Place 1 Floyd Norris .


mukcr In MFS optinns nf ~ h nChlcop,o nnrhrrl 1)uycrs hnd lnstdc Information.
'A merger dcal shows once Opllons E*chnnec. Hcrilornln Nltktl. nn olliclnl of A sp3kc~wdm~n for the Chlcntn owchonge Inid
- - - - - Opl4ntls Hcsnurcc Group, snld the lnstltrhtlnn Ittnt "lhc ewchanfis Is conductlnu n routine lnqulry on
again that i t *all
~ in the timing. sold the Opfions had hccn ollerlng to scll tho cltlls thc irndlng." trul would ~ lcornmcnt
l further.
lor a subszantint pcriod o l timc &tore hls Rroup Such Inwstlgations arc rndnd rrmrkrc. but they
bought Ihcm. He w w l d not Idcnllfy tllc Insrlthitio~l. Pre Rllt oftcn that producrlvc. The crrhangcs can
OMETIMES 11 jusr doesn't pay to hcdne, Mnrkcl n~nkcrs!alund rcndy In buy nlld scll
S On Friday n l t e m n . nn lnstltutlonnl ln-
vcstor, tvldcntly conternd that an Invosl-
mcnt In M P S Cornmunlratbns was not movlne.
olltlnns. 1)ut nrity I f tllc crlvtnnlar In wllllng to do an
a1 R "hld-nskcd'' liprcird. I r l thls cnrc. lhc Instltu-
rinn wnr w r l H n ~to scll thc aptlnns only ul the
gcr brokeroga llrma tosay who the customer was.
but lhay cnnnot tnrco the customer to tcsttly.Thc
Sccurlllaa and' Exchange Cornmlsslon can lasuc
subpocnal. but If a cuslomcr ehooxs to rcrnaln
bcelded to pick up o little Income by *clllny: Cull h i ~ h e ra d d ~ ~ I C C80. L l hnrl l a wnlt for wnlcnnc allont, or dcnlcs dolnc nnylhing wrong. Illrlc cnn
options an the slack. m nGrcc In ~ h truda.
c h dune u n t m the tnvcrll~alomcnn prove how
Ihe call options would give the buyer the right I I Inst& Informntlon came to Iha cuslomer. m a t i s
ro putchnst hlFS stock at s~clfilrd'prlccunlll I'or the InsltluHnn. tlle trade b r w g h l In $43.750, oltm vcry dllllcutt to accomplish.
Sept. 20. when the options would ewplrc. The less co~nnllsstons,but thc Institullon mlsrcd out In lnlcrvicws ycstcrdny, execurlvcs from the
income tmm selling the colls wmld provldc the on the gain from ycsterdny's bll: run-up In MPS two cornpanlcs sold they hnd done rveryrhtnk
lnslliutlm wlih a partlol hedge against any dc- shnrer. Ar for ~l~c.Olbtions Rcsor~rccCroup. Ihc p s l b l e to keep thc deal comtldentlal. and cx-
cllnc tn the Pw)r prlce. The rlak was that Ihc trrldc could hnvc pruvlilcd n windlnll slrtcc tltc prusrcd surprlac ar qucsltona regarding ~ r i l l l c
~nstltutlon would miss out on lhe galns II t h e sfmk op~lotm.wl\lclt i t tmu~lttInr $1.75 cach. closed lnsldcr l r d t n p . ncmnrd J. Bbbers, thc president
was to r l K sharply bctorc the cxplrallon datc. ycstcrdny at SIO, lor a total vnluc ot f250.000.111er
hnd trtdred them w m a rise. Yesterday it wns
nnd chlct crccurlvc ol Worldmm, snld. "I don'l
rrndlng as hlgh as 511.A75. llur Options Rcmurcc, know nnyfhlnp obnul it. and I don't know how yau
announced thnr MFS had agreud to be nequlrd
by Worldmm Inc.. with each sharo of MI:S to bo
c ~ c h m g e d tor 2.1 shnrts of Worldcorn. MI:S
tw, hr~d
E R I C by sclllnf. so~llvMPS &lock slttbrt
bnrrnwlng shurcs nlrd svllttrg 1t1cln. ThO chOrt
-
hcd&cd,ltsposlllon. Mr. Nilkit ~ a l d1.11thls
111111 Is
cnuld knirw about It." HE nddcd, "I nm absolutely
n ~ n r ~Ilyz dtruw we nrc alrlu to do this dcnt withaul
shares shot up, and with them tha vnlue of Ihc p s l l i n n Inst mnney whcri tltc stock raw, bccauso ally word galtln(l wt."
options. MFS ended the dny at $41.81. up $9.94. the eharcs sold short must be rcpurcherd nt H c nnd James Q. Crowe. the charrman 01 MFS,
Acrlvlty tn options just before thc nnnounce hlghcr prlccs. So rhc losrcs on the short pUHlllnn sold lhcy hammered out ~ h cdcrl ln two weeks.
mcnt 01 a deal ottcn shows slgns of hslrtcr Inrgely olfsct the proilt on thc oprlons trade. Worldcorn's board mcl.on Pr~dayl o discuss tho
trad~np.and thcrt may hnvc been somc of [hat In Mr. Nltkn saltl I l l s llrm lnst l ~ t n t ~ ovur
c y nll or1 dcal. and npprovcd I t on Sundny. The MI'S &aid

bjgptst b l c ~ ofk that day -


thc trading al MFS oprjans on Frlday. Uut thc
250 ~ p i l o n scontracts.
ttlc tabcovcr. Iar(:cly hccnusc of snlm ot c:~!t
uptlons tbllowill(l rlw huycr to purchasa MPS stock
at 540 n share. 'lltosc optlnns wcrc purchasd by a
mct four llrncs on the dcal In the lust rum weeks.
h l o r c upprovlnp IL on Saturday.
"Wc t m k cxtruartlinary mcssurcs ro kccp rhls
cach of which allows lhc lwycr 10 purrhaw 100
J h n m of MFS at U S t l ~ m g h
to bo a c w c of wmethtn~clro.
Sept. 20 - apptnrs n~rnillcrof brokcrnl:c I w u K S on I'rldliy. wltctl
MFS wrrs trndln~; nruuntl 533. Conlrncls llbat SoHltrl
nnnuunccment confidcntlal," Mr. Ctolwe soid.
Whclhcr t h optsons
~ scttvlty rcf~ccts thc rahlurc
7he buyer of the opttont win* rho O p t m s R e Inr 50 cc~ltsnnd lcng ott Frldny cndcd ycstcrday ot of lhosc mc;rsurcs, or just somc ~d luck. may
rource Crmtn. the dcslgnatM primary mnrkst $5.15. I t Is cnncclvahl~fttnt sntna at (Irosv nptli,nt novar tm IImwn.
Percs
. ,

"PreferredEquity Redemption Shares"


Debt securities exchangeable into common stock (not necessarily stock of
issuer)

In exchange for additional coupon investor forgoes equity appreciation


above cap level ,
- ~nvestor~artic$at'esfull~innppreciationuptocap
- Investor has full downside exposure on the stock

Investors are effectively buying stock and selling "out-of-the-money" ' .

calls

Derivatives permit investors to express preferences between capital and )

di.vidend/income returns
Percs example

, . Price: $20 (same as the underlying stock price at time of issue)

Conversion Price: $25 (25% premium)


> -
,
Maturity: 3 years

Coupon:- l 6% of issue price p.a.


Conversion: If stock price < conversion price, one share per perc
If stock price > conversion price; shares calculated by
dividing conversion price by stock price .
-

Seniority: Preferred stock of.i ssuer


r-

Listing: NYSE or exchange wherecommon is listed


Stock dividend: 2109% pea., . ..
Percs valuation

The strike level of the "out-of-the money" Call and the incremental
dividend are variables which can be adjusted

-
CaII value spread over life of Perc at
issuer's discount rate of 8% =
4.00% per annum
10.31% Call Value

Yr 1 ' . Yr 2 Ur 3 Common dividend


- , ..
Total return swaps

College endowment fund has invested $40 million in a long term fixed
income portfolio for many years

Active fund manager has consistently underperformed their benchmark,


the Lehman Brothers Government and Corporate (Long) Bond Index-

College looking to improve cost/performance balance


Solution: Index swap with bond portfolio

College invests cash in portfolio of .

bonds
Portfolio
.- High quaZity(AMAA) tominimize ~orh Flmr Plan Lihor + 13
credit risk A 7 T Crcdi~Cards 1,ibr + 12.5
First USA Credit Cnrd Lihor + 24
- Libor basedflows oflset swap liability Nationshqnk Ploalcr Lihr + 15
First Chicago Plonter Lihor + 13
Portfolio is held in JPM Asset Account
-
and pledged as collateral ngninst
exposure ,( ) , L i b o r + ! - 1 5 bps ,

College and Morgan enter into total


return index swap Client
- Morgan pays cumulative appreciation of
index a1 the end of 5 years Lehmiin Li bor +5 bps
. Index
- College pays any index deprecintion,
plus periodic interest cost
JPM
Strategy should result in outperformance
-
relative to the index
Why use total return swaps?

passive investment philosophy


- Client may want broad market exposure
- M a y not believe in "alpha"

Lower transaction costs


- Client &n share in cost snv jngs i f h a l e r usex futures

Operational convenience or speed of execution


Create synthetic short positions
. - Go short markets where "plzysicnl" transactions are expensive or d i ' c u l t

. Financing transaction
- Use dealer's balance skeet and funding access '

Tactical asset allocation


- Switch out of existing portfolio into ofhe; asset classes
Exploiting interest differential'sin international markets
Mechanics and outcomes . . - ,

Today

Lender

,- u
,-,
11 Borrow
Yen tOO million @ 270

Yen b
Yen 102 million
@ 3213.00
sell $850,000
$220,000 profit

@~oo.o~
sell $1.02 million
$50,000 profit

1 @95.32
Buy 7% bonds /OO.OO
(1 - $1.07 million
sell $1.07 million
break-even

0 Bonds e85.00 . -
sell $1.2 million
$130.000 loss
,
Forward contracts
*.

, Since Forward Exchange Rates are calculated using interest rate differentials
between the two currencies, the outcornes.should be the same as thk "physical"
transaction

The forward market is liquid and generally involves lower transaction costs

Possible oritcomes
al varying Yen/$ rates:

Sel I I yenr 's time scl I$850,000 .


Yen102 million $220.000 profit

-el00.00
sell $ f .02million
$50.000 profit
BUY Spnr FX Rate: , .
$1.07 million 1
sell $1.07 million .
break-even

@85.00
se11.$1,2 million
$130,000 loss
Please kccp in mind ...

This hooklet is intended lo inform you of products i~ndscrviccs cdTurcrl hy This miiwri;~li s not intcndcd ;ts an nrrcr or solicitii~ionCur ~ h purchase
c
J.P. Morgan. I.P. Morgan i s the markcling namc Tor J.P.Morgan nt Ca. or s;dc nl'itny linancial instrument. S ~ c i f i crclcrcnccs arc lor
Incoqmrated and its subsidiaries worldwide. Rcfercnccs to "J.P. Morgiln" illustrative ptlrpscs only. J.P. Morg;in rnay hold n position or acl as
encompass its worldwide network or suhsidiarics. including Morgiln mnrkct tnakcr in the linnnviat in.~lrumcnls or m;akcls rclcvant to MPDs.
Guaranty Trust Company of New Yark, J.P. Morgan Sccuritics Inc. J.P. Morgnn may cng;lgc in hcdging ar olhcr optalions in such markcts
{JPMSI),and J.P. Morgan ~nvestmentManogcmcni Inc. J.P. Mnrgnn rclcvrint to i l s MPD cxpnsurcs.
Securities Inc. JPMSI i s a member of the New York Slouk Exchange, lnc.,
the Narionat ~ssocin'tionoisecuritics Dealers, Inc., ant1 the Sccuritics JPMSl's ohlig;~~ions and lhc sccuritics sold, oflircd, or rccom~nended'
Investor Protection Corporation in the Unilcd St:llcs n~lrltllc Sccuritics :mtl hy JPMSI iIrc not dcpnsifs ant! :ire not insurcd hy the Fcdcral D e p s i ~
Futures Association in the Unitcd Kingdom. Insurilncc Corporalinn, Ihc Fcdcml Rcscrvc b a r d , or any nlhcr
~ovcrnnicr~t:~l ;igcncy. JPMSI is not i t hink :~ndis :I scparalc legal cntity
Opinions and estima~esorrered constilule our judgnlcnt and arc suhject to liom its bi~nkilnd thrin atfilialcs. Thc ohlig;trions oC JPMSI arc not
change without not ice, as are statements on linanciihl tnarkcl trcnds. which ohliglions or its hank or lhrirt nffilia~cs(unlcss explicitly sralcd
art baed on current market conditions. We heticvc rhe informi~tion arc not respnsihle for securities sold,
nrhcrwisc), and lllcsc irrfilii~~cs
provided hcrc is reliahlc, hut i t should no1 he assumed In hc eichcr ol'rcrcd, or rccclmmcndcdhy JPMSI.
accuraie or complete. Past performance is no1 indicalivc of tt~lurcrcsalts.
Additinnal infonniilian is avnilahlc on rcqucxl. 0 J.P. Morgan & Ca.
The views and srraregies dcscrikd may no1 he suilaMc for all invcslors. Jncflrporillcd 1906.
This presentation i s not intended to provide, and should not he rcticd on
for. accoun~ing,legal, or lax advice, or investment rccornmcnda~ions.You
should consult your tax or legal advisor q h u t the issues discussed hcrc.
.Derivatives and Structured Products
Autumn Derivatives Seminar

' Session 3: Hedging and Diversification Stmtegies


Agenda

Overall considerations

Market, regulatory and tax considerations -,

. Hedging and diversification strategies


- Stock sales
-.

- Equity puts
- Cashless collars , .

- Short againstthe boxwithamarginloan

- Equity linked loans


- Exchange Funds - .. ,.. .,
- Charitable Remainder ~ r i i i t s
Overall Considerations

Current posltlon
m .

Conside ons / constr


., .
Future obiectlve

.. Current overall asset ~ o r of


h ownership Desired risk / return
,- allocation profile

Amount of wealth in single Potential tax liability for Ultimate beneficiary of


stock low tax basis stock wealth

' -Viewson current risk .. Current and future tax Time horizon
/return of assets position

Regulatory restrictions and Income needs


reporting requirements
Market and Regulatory 'Considerations

Market considerations
- Daily average trading volume
- Size of holding relative to market capitalization of company
- Investor demand for large blocks of stock
- Depth of stock lending market
Regulatory considerations
- section 13(d).
- section 16
- Rule 144/ 145
- CFTC restrictions
Stock Sales

Liquidity is generated

Tax cost can be significant

,
Risk is reduced through diversification
- Most appropriate for those with long timk horizons

Stock sales plus tax advantaged/deferral vehicles can make sense


Equity Put

Single stock
Provides protection against a decline in the returns
value of a single stock Client
Client pays an upfront premium and, in return,
MGT.agrees to pay the difference between the -
strike price on the put and the market value of
stock at maturity

Strike prices can be set at-the-money to lock in At maturity,


maximum of: 1)
100%of stock value today or can be set out-of- zero and 2) strike -
the money (10%-20% below the current price price minus stock
is common) price multiplied by
Upfront the number of
premium .options

Morgan Guaranty
Trust Company
1
Cashless Collar

Same downside protection as put option, but Single stock


upfront premium eliminated by giving up some returns
potential upside in the stock Client
Consists of buying a put and selling a call with
same maturity
- Specify level of downside protection
At maturity, maximum of: 1)
needed (e.g., 10%-20%OTM) zero and 2) put strike niinus
- Strike on call set to generate premium to stock price multiplied by the
. pay for put - number of options
I

At maturity, maximum of: 1)


. At maturity, payout of the collar depends on zero and 2) stock price minus
market value of stock . the call strike multiplied by
the number of options
- If share price < put strike, MGT pays
difference between put strike and +market
price
- If share price > call strike, you pay ; Morgan Guaranty
difference between market price and call
strike Trust Company
-
Short against-the Box...

,Execute short with borrowed stock: equity


risk neutralized
Borrow up to 90% of the value with a
margin loan (loan proceeds are available
to reinvest in public securities) I
Stock "in box"
, Closed at any time with 3 days' notice; (via margin account) Rebate income
-
. typically used at year end to defer gain to
next year Sell borrowed
stock
J.P. Morgan
Securities
, 1 Cash
I
Cash
, Stock Loan Collateral Rebate income
With a margin loan

Pay floating rate interest on margin loan New returns


outstanding
Client
Net cost = rebate income - margin loan
interest Reinvestment
I
Interest on
margin loan Margin loan

J.P. Morgan
Securities
I
,. Equity Linked Loan

Loan is secured by underlying stock plus


additional collateral
- Interest payments equal annual spread.plus Client
any dividends paid on stock
- Amount of loan repayment equal to market
value of stock, subject to minimum
. repayment amount of 50% of initial loan
proceeds

Equity risk neutralized: change in value of stock


secured
loan I
$10MM of
spread o
$I OMM
offset by change in loan repayment amount shares plus
additional Market value
cash' from loan is available for reinvestment or collateral of shares
pledged at maturity
.other purposes

Additional collateral required depends on credit


analysis and how the loan proceeds are invested
~ o r ~ Guaranty
a n
Not a disposition of underlying shares for tax Trust Company
purposes
Equity Swap

'
Total return of underlying stock exchanged for
total return of market index such as S&P500
Index
Underlying equity risk neutralized:
- Any decline in value oEstock offset
by payment received under swap
- Any increase in value of stock Annual Stock
offset by payment due to Morgan spread depreciation
. under swap plus dividends -
,
Total return
of S&P 500
Fixed cost equal to annual spread on initial Stock Index
market value of underly ing 'shares . . . appreciation, I

Not a disposition of underlying shares for tax


purposes
*
Swaps against other market indices such as Morgan Guaranty
fixed income or international equities are also
available Trust Company
-
Exchange Fund

Clients contribute shares into an "exchange" or


"swap" fund established by JPM as the general
partner
In return clients receive partnership units
representing pro-rata stake in all contributed
shares

At the end of the holding period fund is '

. liquidated

Single stock risk is exchanged for diversified


portfolio (up to 99 shares)

Clients retain original tax basis in the shares on


distribution Exchange
Fund
I
Charitable Remainder Trust

Low basis stock gifted to Charitable Remainder


Trust -
. -
client
Trustee can sell stock without incurring ;

capital gains tax


- Trustee reinvests proceeds in diversified
portfolio . Gift low
basis stock
You (and your spouse) receive an income I b
Annual inc me stream
payout for life; charity or family foundation
receives remainder interest '

'* Allows tax free diversification while meeting


.long term charitable intent
- Tax deduction for present 'value of future
gift to charity I .
Remainder interest
- Wealth to heirs can be replaced and
increased with insurance and/or CRT t -
with heirs as income beneficiaries
Qualified
Reportable as gift byinsiders Charity
Comparison of Diversification Strategies

Equity
Short vs. Linked Equity . Exchange
' Sales TheEhx - - S w a a Fund CRT
Defer capital gains Low Moderate Moderate Moderate High High
Investment flexibility High High High Moderate Low High
Provides liquidity High High High ' Low Low Moderate*
Long term solution High Moderate Moderate Moderate High High
Rollover risk Low High High . High Low Low
Certainty of cost High Low Moderate Moderate High High
Control of assets High High High High .Low Low,

* Income only
Case 1.:Structuri,ngthe appropriate vehicle

c11-l QFl
Jack Ellis Jr. Vanessa Ellis lare Matthew Karen Corsair
Stock price

John ~ l l i s Jar Matthews Vick Corsair


-43,146 43,145 30,343

Richard Ellis lisa Matthews Dennis Corsair


43,146 43,148 30,343

Klye Ellis James Corsair


. 43,146 27,400

Oct 95 '; Oct 96


Travis Corsair
22,747

Luke Corsair
22,717
Case 2,: Monetizing illiquid preferred stock . .

At inception: At maturity:
Market . . Market

Zero-coupon ' A

Cash ( 1 9%) Cash ( 100%)


Note (25 yrs)
' Stock v, Stock I
Dividends Thst Client Trust
- 1
Cash
(81%) Notes Cash (1 00%)
Cash (1 00%)
r

Investors
-
-Please keep in mind ...

This booklet is intended to inform you of products a i d sewices offered by This material is not intended as an offer or solicitation for the purchase
J.P. Morgan. J.P. Morgan isthe marketing name for J.P. Morgan & Co. or sale of any Xnancial instrument. Specific references are for -
Incorporated and its subsidiaries worldwide. References to "J.P. Morgan" illustrative purposes only. J.P. Morgan may hold a position or act as
encompass its worldwide network of subsidiaries, including Morgan market maker in >he Xnancial instruments or markets relevant to
Guaranty Trust Company of New York, J.P. Morgan Securities Inc. MFDs. J.P. Morgan may engage in hedging or other operations in such
(JPMSI), and J.P. Morgan Investment Management lnc. J.P. Morgan markets relevant to its MPD exposures.
Securities Inc. JPMSI is a member of the New York Stock Exchange, Inc.,
the'~ationa1Association of Securities Dealers, Inc., and the Securities JPMSI's obligations and the securities sold, offered, or recommended
Investor Protection Corporation in the United States and the Securities and by JPMSI are not deposits and are not insured by the Federal Deposit
Futures Association in the United Kingdom. Insurance Corporation, the Federal Reserve Board, or any other ,

governmental agency. JPMSI is not a bank and is a separate legal entity


Opinions and estimates offered constitute our judgment and are subject to from its bank and thrift aPAliates. The obligations of JPMSl are not
change without notice, as are statements on !Anancia1 market trends, obligations of its bank or thrift aphliates (unless explicitly stated
which are based on current maiket conditions. We believe the -information otherwise); and these af'hliates are not responsible for securities sold,
provided here is reliable, but it should not be assumed to be either offered, or recommended by JPMSI.
accurate or complete. Past performance is not indicative of future results.
Additional information is available on request. O J.P. Morgan & Co.
The v i e w s k d strategies described may not be suitab~kfor all investors. Incorporated 1996. '
This presentation is not intended to provide, and should not be relied on .
for, accpunting, legal, or tax advice, or investment recommendations. You
should consult your tax or legal advisor aboui the issues discussed here.
Welcome to SunGard Securities Processing Page 1 of 2

Account rhk rruamrnt (ARM)


EIecfmnk statemants/rcport. (dolk)
Alloutions/aaims processing (FACT)
Internet inquiry
CCP initiatives
Futures

dutions
Fa~tsr
GMI
The GMI System is a powerful back-office clearing and accounting
octagon
Devon software solution for the global exchange-traded derivatives, equity
Gbbal Margin Server and equity option marketplace. Clearing firms, securities firms,
GDS Prldng Data brokerage houses, emerging derivative playen and the regionalized
WorMSouKe investment community rely on GMI every day for acquisition,
Exchange Gateway processing, management, dissemination, integration and booking of
Aud ITrade all clearing and trade processing actiiitiis for virtually any
AudITlack exchange-traded instrument.
Supported Exchanges
Professional Servlces
Tralning/Dmmentatlon GMI removes manual processes and provides comprehensive,
Futures News consistent and accurate information 24 hours a day in one integrated
Industry Links accounting system. It ensures that resources are better allocated, so
Futures Contacts
Customer Login your firm can remain competitive and control costs. GMI also
InWathr provides links t o the world's exchanges for automatic trade capture,
pricing updates, margins and risk arrays.
Phase3
stream
Among GMI's core capabilities:
STNs e t t k m w s
Wdl S L C t n l ~
Automated Point Balance
Automatic Reinstatement of P&S
Auto-Maturity of Government Instruments
Collateral Allocation and Management
Commissions and Fees
Credit Compliance
Dividand Processing
Document and Papars Maintenance
Equity Options Processing
floor Brokerage Tracking
Foreign Exchange Processing
Give-Out Statemants
Haircut Cakulations
Interest System
Integrated General Ledger
Multipk Broker Table
Multi-Currency, Global Rocassing
Multi-Firm Processing
Philadelphia Currency Pmassing
Random Assignment of QpUons
Real-Time Pricing
Regulatory and Year-End Tax Reporting
Single Currency Margins
T-Bond Processing
Warrant Processing

GMI supports the following instruments:

Future and futures options


Foreign exchange
Over-the-counter options
Stocks, rights and warrants
Equity, non-equity and currency options
Corporate, municipal and sovereign govarnmnt bonds
Welcome to SunGard Securities Processing Page 1 of 2

Futures

rcplutlans Devon
F*m8
GMI
The Devon Exchange System provides back-office processing
octagon
Devon requirements of firms participating in the European exchange-traded
Global Margln Server derivatives markets. Designed for smaller firms with low-end volume
GDS Prklng Data requirements, or for use as an adjunct to outsourced services,
Worldsource Devon is a powerful yet cost-effective solution with real-time
Exchange Gateway processing, full multi-currency account management and extensive
AudlTrade exchange-interface connectivity.
AudlTtack
Supported Exchanges
Professional Servlces Devon provides the ability to receive, process, and turn around trade
Tralnlng/Documentatlon information quickly, and is ideal for providing time-sensitive and
Futures News accurate trading information to multiple sources immediately after
Industry Unks market close. The system offers trade interface connectivity with a
Futures Contacts
Customer Lqln stable and efficient processing platform for the clearing and
Irbwwhlr settlement of exchange-traded futures and options and related OTC
contracts.
PhaPs3
Stream
Devon provides the following features and advantages:
ST84 ikttlcmcnt*
Wall St Concepts
Option of registering trades directly and automatically from a
trade source, such as an exchange matching system or third
party trade interface, or by direct input

Provides trade validation by a designated user to prevent


incorrect or unauthorized entry of transactions into the live
environment

Interfaces with exchanges, SunGard's Worldsource, or other


price vendors for contract settlement prices

Ability to apply a range of limit controls to monitor


transaction activities in volatile or tightly regulated markets

General Ledger postings for double entry bookkeeping, which


can be incorporated into a central GL accounting system
within the organization

Automatic generation of trade confirmation records, which


can be output as customer stationary, altowing users to
define fields, look and feel, size and proportion of
information on each page

Generates commission schedules, ranging from exchange


fees and clearing commision, to clearing feas and floor
brokerage

Extensive and flexible reporting for customer stationary,


regulatory reporting and information access; both standard,
pre-defined reports, as well as ad hoc, user-specific reports

Runs on MS Windows MT or 2000 operating systems, and is


available as a stand-alone or networked system

You might also like