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Dr. Risk promises you at least a brief response to your important question, as soon as he has a free moment. A question of sufficiently general interest to make it into the 'Zine, tends to generate a more comprehensive response. Your questions become and Dr. Risk's answers are the property of The William Margrabe Group, Inc
8/28/00 Equity-linked Notes (7/28/00)
Dear Dr. Risk I want to know about Equity-linked notes. Most of the time, these equity-linked notes are offered for blue chip companies like IBM, Ericsson, Nokia, etc. I want to know whether they are the right vehicle to invest in and what could be the pitfalls? Can anyone influence the prices on the Option expiry date? I shall appreciate if you explain the mechanics of these notes and their pricing. Also, can their pricing be different? Looks like there is a connection with options. In that case, why not buy options? If yes, how to go about it?. – Lal
Dear Lal Asking Dr. Risk whether equity-linked notes are the right vehicle to invest in is like asking Dr. Ruth if heterosexual sex is the right thing to do. It all depends on what you’re looking for and the particular kind of equity-linked note (or sex, in the Dr. Ruth case) you’re considering.
One pitfall is that the equity-linked note could be a clever snare for the gullible, and you might not notice. However, determining that requires the details that Dr. Risk doesn’t have.
Typically, equity-linked notes trade over-the-counter. The dealer controls the asking price and has salesman dialing for dollars, looking for customers willing to pay it. If the customer says no, the salesman says goodbye and makes another call. This is in contrast to an options exchange, where the market price at an instant depends on market supply and demand and is relatively fair and objective. Dr. Risk has known traders who have claimed to manipulate the underlying market to influence an option's payoff. A trader might try to pull the same sort of trick in the equity-linked note market.
As you mentioned, typically an equity-linked note has an embedded option component. It is a note, minus some principal and/or interest, plus an optional coupon or principal payment that depends on the equity value. The investor loses some cash interest or principal and gets an optional payoff. The dealer's challenge is to do this in a way that "adds value" -- to the dealer's P&L. Often the dealer puts the note together from ordinary debt and options, as a child might put a toy car together from Lego components.
If you recognize the method of constructing the note, you could possibly do better by trading in the component markets. Look at one of the major option exchanges for equity options. Dr. Risk
Dear Dr. Risk Thank
you very much for your reply. In fact, I don't understand options and I am
told they are hedging instruments. Would you advise me of any Web link to some
material which can educate me on this.
Dear Lal Buy
a book about options. A good textbook has more information than you can
currently find on the Internet. If you cannot afford to buy a book, you have no
business thinking about buying options. You can consider some possible books on "Dr.
Risk's Bookshelf." The
Options Clearing Corporation and some of the options exchanges provide some
information about equity
options. See links from this page to
A Problem that Dogged Katzenberg (7/28/00)
Dear Dr. Risk I'm trying to determine which is the best model to value my company's stock options for executives. The choices appear to be either the binomial model or the black-scholes modified for dividends. Which model should I use and why? – Dan
Every question has an answer that is short, simple – and wrong. Sometimes – as in your case – it has two such answers.
The price of an executive stock option depends on the same basic factors as all other derivative products: (a) the relevant contract and (b) the dynamics of the underlying risk factor(s). If – and this is a BIG IF – (a) your company's executive stock options are simple, European call options and (b) the underlying dynamic process for your company's stock price is log normal diffusion – the logarithm of the underlying price jumps around randomly, with a variance that is proportional to the time interval – and the option is a simple European call option, then the Black-Scholes with dividends would be a reasonable, simple model. If the options are American, then Cox-Ross-Rubinstein or Jarrow-Rudd with dividends could be appropriate. If your company's stock has traded options, then you might even find the volatility that you need.
If (b) the term structure of interest rates isn't flat, you have discrete dividends, and/or volatility has a smile structure, then Dr. Risk would recommend any of a number of other models with more appropriate assumptions. The precise model depends on the precise assumptions. Dr. Risk and and others build bespoke models to fit specific circumstances.
However, the situation is ordinarily much worse than this. If (a) the company can cancel the options for poor executive performance (or just a whim) or the executive loses the options for jumping ship or (b) a change of control for the corporation accelerates the expiration date and window for exercise, then you are in a much more complicated situation, with the problems of asymmetric information and moral hazard. Option pricing doesn't deal so easily with such issues. Dr. Risk has have seen models designed for such cases and wouldn't bet money based on them. Nor would you find a trader willing to bet on them, either. The idea that a professional market maker would have made a market in (say) Jeffrey Katzenberg's ESO's from Disney is ludicrous.
The price depends on whether you are buying, or selling. You'll buy at the (high) offer and sell at the (low) bid. The bid-ask spread can be sizable.
The (appraised) value can depend on the purpose to which you want to put it. These reasons fall neatly into two categories – those that call for a high price and those that call for a low price. Dr. Risk is being serious, here. If you want a value for your income tax return and a high value leads to higher taxes, then you probably want a lower value. All appraisers take this into account when appraising property for tax purposes.
The proper solution to this complicated pricing problem starts with design of the contract, to encourage desired behavior, discourage unproductive game playing, and make pricing simpler. Think of the medical analogy. If you went to your doctor at age 65, overweight, diabetic, and with a serious heart condition, and asked him what to do, he wouldn't be able to undo all the damage you had already done. If you went to him at age 25, he could tell you how to lead your life, and he could get you started on the right road to avoid problems not that anyone would pay any attention to such wholesome advice. Dr. Risk
A Concrete Answer to a Hard Question about a Cement Company (7/28/00)
Dear Dr. Risk What does the EV mean? (Different from EVA, We came across this term in a report by CSFB) How do you calculate it? – Gaurav
Dear Gaurav Obviously, EV could have any of thousands of meanings. Which report? What was the context? Without further information, my expected value (okay, maybe just modal value) for random variable EV would be "expected value". Dr. Risk
Dear Dr. Risk I'm
sorry I was not clear about my question earlier. I came across this term EV in a
report by CSFB Hongkong (Equity Research, 26 July 1999) which was about the
cement industry in India titled Indian Cement Industry: Swinging into a Deficit. It
was used as a parameter for valuing companies. It is not Expected Value. Ratios
Dear Gaurav In this context, EV is the acronym for enterprise value, which equals the total value of the company’s equity and net debt. All these ratios are tools for looking at the firm’s value, compared to its scale of operations. An equity analyst might try to use them to asses the firm’s relative value, compared to similar firms. For more definitions that involve EV, see http://www.csquest.com/Web_User_Guide/appendix4.htm. Dr. Risk
The Best Is Yet to Come ... (5/28/00)
Dear Dr. Risk I am interested in issuing options on multiple assets, that is not a Rainbow option on two assets. I would like to price an option that gives the four bests stocks out of ten at expiry. Do you know any good articles about this or how to hedge theese options? Henrik
Dear Henrik We know that we can find the risk neutral probability density function from an assumed multivariate lognormal pdf by a change of measure that involves keeping the volatilities and correlations and changing the drift to r-d-var/2 for each of the assets, where r is the rate of interest, d is the dividend yield, and var is the volatility-squared. I think this result now appears is in textbooks, including Hull's Options, Futures, & Other Derivatives. To price a European payoff, we can multiply this pdf by the payoff function and integrate over all dimensions. Integration in many dimensions is difficult, and sometimes Monte Carlo is the only way to go. Getting Greeks via Monte Carlo is difficult, but we some highly accurate, proprietary techniques. Moreover, this all depends on stable volatilities and – worse – correlations. Dr. Risk
Asian Options and Swaps (5/28/00)
Dear Dr. Risk I was wondering if you could point me to the right direction where I can find information on Equity Derivatives (Equity Swap, Options, Warrants, CB's, etc etc) for Asian Market especially. Lil
Dear Jim Thanks for asking Dr. Risk about equity derivatives. However, he's a bit puzzled. Your E-mail appears to originate from a firm that had an active equity derivatives department, last time Dr. Risk worked there. Of course, some people left to go to another firm, but many stayed behind. So, Dr. Risk believes that your firm has a vast amount of documentation on the subject, as well as many qualified persons. Dr. Risk refers you to [names deleted] for more information. Also, your syndicate department is a pioneer in and major underwriter of derivative securities. They have much literature, too.
Dr. Risk would suggest, also, the book, "Equity Derivatives; Applications in Risk Management and Investment," London, Risk Publications, 1997. It's available in hardback and paper. It doesn't appear to be at Amazon.com, but you might try to get it through "Risk" magazine. Dr. Risk is a contributor to it, but would recommend it even if his chapter weren't there. Also, you might try to get "The Handbook of Equity Derivatives," edited by Jack Clark Francis, William W. Toy, J. Gregg Whittaker, which is a classic, now out of print. You may find it in a bookstore, such as the McGraw-Hill Bookstore, if you work in New York.
A number of other volumes that Dr. Risk hasn't held in his own hands are available at Amazon.com. Dr. Risk
Links Links related to equity are below. Links related to other financial topics are here.
Derivatives DictionaryTM Terms and definitions relating to equity are below. The main Derivatives DictionaryTM is here.
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