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Downward risk shield through stock options
Since implicit equity volatility is available at historical low and equity options at lower costs, Ed Wilson examines how performance-based plans could use equity options policies to mitigate risks. World equity markets are at historic high lows, with recent data showing that the rally continues through 2016 and 2017 (e.g. the FTSE 100 is well above the 7000 level).
The majority of share-owned post-employment benefit systems will have performed well in this area and do not want recent profits to fall significantly (see Chart 1). In spite of recent developments in equity market developments, there are many geopolitical hazards, among them strains on the South Korean stock market, uncertainties over US policies, Brexit talks and the EU's overall sustainability, as well as the increasing risk of malignant cyst disruptions that could all create a headwind for world economies.
Implicit short-term equity volatility has recently declined in most equity indices, as reflected in the VIX index (see Chart 2). VIX Index is a measure of implicit volatility for S&P 500 stocks and is the most widely used short-term benchmark. Implicit volatility is an important determining factor in the price of options and options are therefore historically inexpensive.
What can stock options help DB systems? Similar to the purchase of insurances, the purchase of stock options can help safeguard the stock portfolios of a system. Similar to the purchase of insurances, the purchase of stock options can help safeguard the stock portfolios of a system. They can be implanted to fully or partially hedge the equity value in the case of a downward movement.
Levels of coverage depend on the costs of such a policy. In view of the recent price setting of such options, it may be a good moment for programme fiduciaries or programme sponsors to consider the implementation of such a policy. So why choose a stock options policy? A number of factors explain why a stock options policy may be desirable.
If, within 12-month periods, an actuary approaches an assessment for a system (or other period), the trustee or sponsors can hedge their equity for that particular one. When a downward trend occurs before the assessment date, the system sponsors can detect a significant improvement in a system's deficits as of the assessment date.
As an alternative, a sponsorship may also retain a higher anticipated rate of expected rate of return on the asset for financial reporting purpose while at the same time safeguarding equity valuation from a negative occurrence. A further example would be an entity with a firm view of the market or wishing to safeguard the present level of equity as a result of a pending ruling or other occurrence.
One of the easiest forms of stock options cover would be the acquisition of put options on a stock index. That means that the options would be paid off when the options expire if the stock index in question is below the Strike Levels (protection levels, e.g. 90% of the initial index level). Many different timeframes and exercise rates are available for the acquisition of stock options.
Chart 3 shows a basic stock put options policy with 90% exercise limit coverage. If the stock index had risen over time, this policy would mean that the options would lapse without value and the system would continue to share in the upward trend of the capital during the life of the options, less the premium payments made for the options.
Schema is shielded against loss below strikes per cent - this can be adjusted at different tiers according to costs preference. Because of the associated premium, independent equity put options can be considered too costly. Put spreads collar" strategies sell part of the stock upwards and part of the extremely disadvantage.
However, such a policy can still offer equity capital down but on a costs neutrality (or reduced) level of premiums and can be a more cost-effective one. However, such a policy can still offer equity capital down but on a costs neutrality (or reduced) level of premiums and can be a more cost-effective one.
The sale of call options gives the system a bonus for the sale of part of the equity surcharge. The sale of stock index enhancements over the term of the options, e.g. over 105% of the initial index value, in combination with the put options for the downward trend, may reduce the corresponding bonuses.
If you go one better and sell part of the extremely disadvantage (e.g. loss of less than 70% of the index's initial value over the term of the option), you can further lower the premia. Implementing such a policy in a premium-neutral manner is possible. Dividend would continue to be payable on the shares on which the system is based.
However, if short-term protections are of relevance to your system, consider at what tier you want to hedge the drawbacks by weighing this against the costs of the policy.