Risk Latte - Equity Collar (risk reversal) on Hang Seng Index (HSI)

Equity Collar (risk reversal) on Hang Seng Index (HSI)

Team Latte
Jul 26, 2005


A lot of institutional investors are apprehensive that the Hang Seng index (HSI) which is trading at a 5-year high could move sideways for a long time or may even go down significantly as a correction, before resuming its up move again. The extremely low volatilities in the index – both as measured by the historical volatility as well as by Risk Latte’s HIXX™, the measure of implied volatility index – has becoming a permanent fixture and there are some who feel that we have entered into a extended period of low volatility regime. Under this regime, they believe that the stocks will continue to rise slowly in the medium term. However, there still remains event risk in the market which can cause sudden drops or could cause volatilities to spike up temporarily.

In such a situation we would like to recommend, especially to the larger institutional investors, who are not very much interested in exceptional yields, but would rather want to hold on to their equity portfolios to either buy or sell equity collars (or equity risk reversals) along with long or short equity positions.

An equity collar or an equity risk reversal is the simultaneous purchase and sale of out of the money (OTM) call and put options to generally create a zero cost structure. The idea is to create a band with two levels, K1 and K2 such that K1 < K2 whereby the two levels act as the strike prices for the call and the put option. Depending upon the directional view of the investors, he can either buy or sell a collar.

We recommend to a small (to mid-sized) hedge fund manager, with a view a mildly bullish view of the Hong Kong equities to go long on HSI futures or a basket of stocks on HSI plus go long on an equity collar on HSI for the medium term, say, one year. The collar is bought is such a way that below a certain level – lower strike – he is fully protected whereas he takes a risk above the upper level – higher strike, and in between these two levels the spot dominates. The trade is long HSI plus a long Put on HSI (at strike level K1) and a short Call (at strike level K2).

Payoff = Long S + Put(S,K2) - Call(S,K1)
where,
S = Hang Seng Index Futures ( or a basket of stocks on HSI )
K2 < S < K1

The above structure is constructed in such a way that it is zero cost, i.e. the manager does not pay price to enter into the transaction.

Which means that if the HSI moves within the band and stays between K1 and K2 in a way such that the market’s bias is still upwards the fund manager’s long position can make money, whereas, if due to any event risk or otherwise the index drops substantially (below the lower strike K2) the manager stands to profit. Of course, since, the manager is mildly bullish on the index, he doesn’t expect the index to go up significantly in one year’s time, but if it does then his losses from the sold call position could be unlimited but his long equity position will compensate for that loss. In fact if the Hang Seng index goes up significantly, defying the manager’s expectations, then his covered call can earn him good profit, since he is long equity with an out of the money call.

With spot Hang Seng at 14,800, a fund manager can choose an upper strike of 17,000 and a lower strike of 12,970 to create a zero cost collar (risk reversal). With a risk free rate of 3% and a dividend yield of 3.15% the BS pricing of the call an the put are show below.

call option
put option
spot
14,800
spot
14,800
strike
17,000
strike
12,970
interest rate
3.00%
interest rate
3.00%
dividend yield
3.15%
dividend yield
3.15%
maturity
1.00
maturity
1.00
volatility
13.50%
volatility
13.50%
 
 
call price =
160.71
put price =
160.75

Payoff = +S - Put(S,K1) + Call(S,K2)
S = 14,800;K1 = 12,790;K2 = 17,000


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