Options and asset management 17 november 2010

Options play a central role in modern asset management Provide important info Level of risk aversion Dispersion Related markets (credits) Hedging Single-name, portfolios Delta, gamma, vega, theta Expressing investment views Covered call strategies Collecting option premias (Insurance company approach) Boosting upside by using dividends to buying calls and so on…

Implied volatility versus price S&P500 Vol is negative correlated to price Before the dotcom crises and credit crises the relationship inversed The level of correlation provides important information to markets participants Early cycle strategy: Sell options Late cycle strategy: Buy options

Average correlation of the stocks comprising S&P500 using index options and options of the 50 largest stocks in the index Implied vol is positively correlated to implied correlation Strategy September 2010: Short correlation and long vol Add exposure index instead of single stocks when correlation is high Implied vol versus implied correlation S&P500

Put-call spread versus implied vol (atm) S&P500 Put-call spread is calculated at delta 10% (blue line) Spread is put vol minus call vol Red line is atm implied vol Put-call spread is positively correlated to atm implied vol Jump-risk indicator Strategy: Hedge jump-risk with put spreads

Credit market Implied vol versus credit spreads A market even more sensitive to jump-risk is corporate bonds (credits) A credit is a very deep out-of-the money put However, two different markets with vastely different market participants Credit market gave early indication of the credit crises

Credit spread can be computed using option model (Merton model) Some adjustment have to be made Volatility of total assets Equity and debt Default point At a certain asset level the bond cease (equity = 0) Barrier option (knockout) Recovery value Usually value left for bondholders in the event of default Recovery value varies with economic cycle

The case of Volvo Theoretical spread vs acutal spread Time serie analysis Far from a perfect relationship But gives indication of when valuations in equity and credit is stressed Red territory, credit is expensive and equity vol high Green territory; credit cheap and equity vol low

Basic Materials Theoretical spread vs acutal spread Cross- sectional analysis Every point represent a company in the Basic Materials sector The straight line represent the fair value relationship

Expressing investment views The case of LCRV LCRV (Loft Credit Relative Value) is a hedge fund which core investment philosophy is to collect option premias and clipping corporate bond coupons – Riding theta Sensitive to large swings in volatility Implied vol was higher in 2009 than 2010