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Endless Leverage Certificates Silvia Rossetto University of Warwick J os van Bommel Saïd Business School, University of Oxford. ELCs. Also known as: Mini-futures (ABN AMRO, Goldman Sachs, HSBC) XXL Waves (Deutsche Bank) Endless Knock-Outs (Dresdner Bank) Unlimited Turbos (Commerzbank)
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Endless Leverage CertificatesSilvia RossettoUniversity of WarwickJos van BommelSaïd Business School, University of Oxford
ELCs Also known as: Mini-futures (ABN AMRO, Goldman Sachs, HSBC) XXL Waves (Deutsche Bank) Endless Knock-Outs (Dresdner Bank) Unlimited Turbos (Commerzbank) Endless Turbos (Lang & Schwarz, Salomon Oppenheim) Open-End Turbos (Societe Generale, Raffeisen Bank) Turbos (ABN AMRO, NL) Speeders (Commerzbank, Citigroup, NL) Mini-future warrants (Goldman Sachs, CH) Power-up (downs) (ABN AMRO, F) Turbos illimités (Commerzbank, F) Turbos ilimitados (Citigroup, E)
ELCs: The main idea If stock goes to €25.25 (+1%) ELC goes to €5.25 (+5%) Tomorrow, D increases to €20.01… (the interest for the bank) The interest rate is Euribor (or EONIA) + credit spread (~ 200BP)credit spread is fixed over the life of the contract! The ELC has a stoploss level, K, of say, €21.00 ( ~ 5% above D) If the stock drops through €21.00, the bank sells the stock, andreturns the proceeds minus D to the ELC holder. The stoploss level makes the bank loan very safe..
D increases daily, K is reset periodically.If underlying pays a dividend, D (and K) goes down. The bank reserves the right to set a higher K if risk increases Holders are allowed to exercise (and claim S-D-expenses). Few ELC-holders even know about this… Instead of exercising, holders sell: Banks quote bid-prices very close to the intrinsic value.(empirically, at most €0.01 below intrinsic, median is intrinsic)
Reasons for Success • Easy to interpret.Easy to find a lower bound value. • Virtually independent of s, rf, Dt. • Easy to hedge (from issuer’s viewpoint)Constant hedge ratio (of unity)
Research Questions: 1) How can we price ELCs? 2) How do theoretical prices compare with market quotes? I.e. are they overpriced? 3) How is the secondary market liquidity? 4) Key hypothesis “ELCs complete the market” They are fairly priced and while offering lower transaction costs than other high leverage derivatives.
Valuing ELCs • If they are exercisable daily, a lower bound is │S-D│. • ELC-holders benefit from limited liability: If the underlying precipitates through K and D at the same time (e.g. overnight), their loss is limited, while the bank suffers a default on its loan. This is known as ‘gap risk’.Naturally, the credit spread is a compensation for gap risk • Rational investors keep the ELC alive as long as the limited liability option is worth more than the credit spread. • Because gap risk decreases as the ELC becomes deeper in the money, there is an unobservable exercise level, E
Valuing ELCs, an Example • Consider an ELC-long with D=100, and K=105, on an underlying with the following return distribution: +20% +20% 0.1% +0.5% +0.5% +0.5% +0.5% 50% -0.5% -0.5% -0.5% -0.5% 50% 0.1% -20% -20% overnight daytime overnight daytime The risk free rate is zero, and the credit spread is 200BP, (which means that every day, D is increased by 0.008%)
Valuing ELCs, an Example During the closing auction, the ELC holder will trade off the cost of keeping the ELC alive, 0.999×D×0.008%, with the value of the limited liability option, 0.001×max(0,(100-0.8×S)) Solving this (with D = 100), gives S = 115 ≡ E* If we further assume that the stock trades at 110 (exactly in between K and E*, we can find, with gambler’s ruin math, that the ELCs value is €10.20, or 2% above its intrinsic value..
Valuing ELCs The limited liability option value depends on the overnight return distribution: stdev 18.2% Kurtosis: 26.0 Histogram of the 25,645 returns of DAX stocks between 2001 and 2006.
Valuing an ELC on a typical DAX stock We set Dt = €100, Kt = €105 and a credit spread of 200 BP. We first look for the E*. We set Et = St =€106. From the pooled historical returns, we draw an overnight return, a open-low return, and a low-close return,..until the ELC is knocked out with default, without default, or exercised, and the bank receives St+Dt , Dt+Dt , orDt+Dt . We do this 100,000 times and compute the average payoff for the bank. If it is less than €100, we set Et = St =€106.10, etc. …until we find E*. Then we set S [K, E*], and evaluate the value of the ELC in this interval.
Sensitivity to Volatility Same thing, but now we artificially increased the open-to-open volatility to 50% and 66% annually
Premium over intrinsic value Dependent variable: Premium over intrinsic as %-age of underlying
Pricing ELCs: summary • The region were a typical ELC should be alive is very small: S (105, 108.2) for longs, S (91.6, 95) for shorts. (% of face value) • The value of the option component is very low, the maximum value is approximately 0.3%of the intrinsic value. However, if the volatility doubles, the option component can be worth 3% of the ELC. • Empirically we see an average premium of 0.67% • Many outstanding ELCs trade far beyond the typical E*
Bid Ask spreads We take five intraday snapshots of bid and ask quotes for all ELCs and covered warrants (“optionscheinen”) written on DAX stocks, on five different days in January 2007. We match them with simultaneous quote snapshots on the underlyings. We focus on leverage adjusted spreads, defined asthe bid-ask spread expressed as a percentage of the underlying value it claims.
Bid-Ask spreads: summary - They are low, significantly lower than for other derivatives. - They increase in the risk of the underlying. - They decrease over their life..
Residual Values When an ELC is knocked out, the holder gets a residual value, │S*-D│, where S* is the “best efforts” price obtained from undwinding the hedge. We collect 1,801 residual values for four ELC-issuers who report (on their websites) alongside the residual values, K and D. We define the residual value shortfall as the difference between the residual value and the theoretical stoploss value│K-D│ (times the ratio, if applicable).
Summary Endless Leverage Certificates are clever SPs + ‘Simple’(for investors to value, for issuers to hedge) + Very liquid(low bid-ask spreads, significantly lower than for covered warrants) + Competitively priced(closely follow intrinsic values) + Small option component - Short life span - Temptation to hold on to them too long - Fairness of unwind process difficult to check
Our recommendations For the ‘investors’ (gamblers):- Do not play with derivatives, you’ll lose, on average!!- If you insist on playing in the stockmarket, go for ELCs. For issuers:- Keep innovating: Lever dependent credit spreads?- Further increase transparency (report open interest, report residual values better). For researchers:- Evaluate ELCs in a world with transaction costs- Look at premiums around earnings announcements
