Options with forward setting Strikes (Case Study)
Team Latte
June 16,2006

Background :

Delhi-Bombay bank, a very large and reputed European bank, has recently hired a veteran equity derivatives structurer, Mr. 2MuchBrain, from Regal Bank of Calcutta to come out with some "rocket-science" equity products to sell to the retail market in India. The bank reckons that the disposable income of average investors in India is currently very high and the middle classes' attitude towards risk in that country taking has changed significantly in the last five years. However, all banks are trying to push the same types of products (under different guise) down the investors' throat and therefore each is losing out to the other. Besides, recent market turmoil in the equity markets in Asia had made some investors very jittery. The head of Asian equity derivatives of Delhi-Bombay bank gives a simple mandate to Mr. 2MuchBrain: "come up with a product that is simple yet very innovative and something that the Indian investors have not see before"

Mr. 2MuchBrain of Regal Bank of Calcutta has had a great track record in fleecing widows and pensioners in Europe with absolutely brilliant "state-of-the-art" equity derivatives products in the mid to late 1990s. So this could be a walk in the park for him and a million dollars in year end bonus. But in the last three weeks the Asian equity markets have gone into a free fall. Some have recovered, gone up and then fallen again. The equity volatilities have increased, which is a good thing when dealing with institutional investors because the bank can charge higher premium for selling options. But the retail investors, especially in the emerging market of India , are suddenly feeling very nervous due to this heightened volatility in the equity market. India's benchmark index Sensex has especially borne the brunt of this volatility.

Product

So, what is that simple yet innovative product? How can we convince the retail investors to put money in a product that can withstand the storms of volatility? He borrowed a leaf from the past and saw that one such product was a capital guaranteed note with an option that has forward setting strike embedded in it. Mr. 2MuchBrain thus came up with a five year capital guaranteed with an option embedded whose payoff is:

If we ignore the capital guarantee part then the note payoff and the option payoff shown above would be the same. Besides, he thought that the product will have a great appeal with the investor. They will get an upside linked to the Sensex in such a way that the strike will be the year end' spot price. If there is market turmoil today, and it is expected to continue, then in a year's time the market has a very good chance of settling much lower than today's value. But in the long run-5 years is long enough-the Mumbai stock market is bound to go up given the fundamentals and hence the upside capture to the investors would be big, and the payoff woul cushion the current market volatility.

Issue:

Assuming an implied volatility of 15% and a starting value of the Sensex of 9,500 Mr. 2MuchBrain asks the rookie in his team to do a pricing of this option. Mr. 2MuchBrain did not want to approach the bank's traders for a price on this product unless he had handle on the price himself. The rookie, a Ph.D. in Solid State Physics does a Monte Carlo simulation on his PC using his own model and gives a price back in ten minutes. Mr. 2MuchBrain, now satisfied that he had the right pricing - or at least a good approximation of it - approached the head of equity linked trading for a quote on the option.

The trader, a long time veteran of the equity markets, made the following comments:

Trader : Your pricing is wrong because a constant 15% implied volatility cannot be used but rather we need a local volatility estimate, which I can tell you right away would be much higher than this figure.

2MuchBrain : Yeah, that's fine, I understand that very well, but can you use give me a quote using local vol.

Trader : Secondly, Monte Carlo simulation is not suitable for pricing in this case.

2MuchBrain : Why, MC simulation is the best thing, my Rookie tells me that and he is a Ph.D., you know these types, they know more than us. Anyway, look.....

Trader : Actually, I don't want to price this product because I will have a great difficulty hedging this exotic option given the liquidity in the Sensex options.

2MuchBrian : Well, most ATM or near ATM options in Sensex are fairly liquid enough and you can get a price easily.

Trader : No, this exotic option will always have zero delta and zero gamma but a positive vega exposure and to find combinations of vanilla options to hedge it is not easy in the Sensex market. Besides, pricing could become a humongous issue!

2MuchBrain : Look, I need a price, this is a great product that we want to sell. Can you give me a price anyway?

Trader : I will try, but it will be very different from yours and much higher.

Problems :

Discuss the above product.

Any comments and queries can be sent through our web-based form.

More Case Analyses >>

back to top