Equity Derivatives Guide

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Derivatives   structuring   is  about  designing   financial
instruments to solve financial economic problems. The
problems that derivatives may solve are virtually unlimited.
Derivatives can be used to manage exposure to a large
variety of risks, enhance yield or reduce funding costs. In
addition, derivatives can also be used to exploit the tax,
accounting   and   regulatory  environment.   Although   the
theoretical pricing and hedging of derivatives has been
dealt with in a large number of working papers, articles and
books, surprisingly little has been written about the
structuring and practical applications of derivatives.
Whenever so, the discussion tends to be restricted to the
applications of a given type of instruments, like index
futures, interest rate swaps or currency options for
example. The same product orientation is also found in day-
to-day practice, where derivatives structurers spend most of
their time on the question which of a given set of products
or combination of products provides the best solution to the
problem at hand.

When the addition of a new product to the existing product
range is very time-consuming, this so-called 'building
block' or 'LEGO' approach seems justified. Over the last ten
years, however, both our understanding of derivatives
pricing and risk management as well as the speed by which
the required calculations can be performed have increased
tremendously. Today, the availability of a general and
efficient pricing and risk management framework makes it
possible for derivatives structurers to leave the   product-
based LEGO approach to derivatives structuring behind and
adopt a more natural and flexible approach. One of the main
goals of this book is to introduce derivatives structurers
to such an approach.

Since our approach assumes that everything is possible, it
allows derivatives structurers to creatively structure
solutions to a large variety of problems in a very natural
way. As in the traditional approach, the starting point of
all discussions is a specific problem to be solved. Instead
of (a combination of) ready-made products, however, the
solutions to these problems consist of tailor-made packages
of cash flows. Whether these packages already exist as a
product or not is only of secundary importance. What is
important, is that they provide the best solution to the
problem in question. We fit solutions to problems instead of
problems to solutions. The reader will see the most complex
derivatives contracts arise as the obvious solutions to
common real-life problems. The approach is an extremely
natural one. The only limit is the structurer's own
Throughout the book we approach matters from the end-user's
perspective. This contrasts with most other books which tend
to take the point of view of the derivatives firm instead of
that of the end-user. This concentration on production
technology is quite surprising if one realizes that the
number of people within a derivatives firm responsible for
the actual pricing and hedging of derivatives contracts is
very small. In other words, the bulk of the derivatives
literature seems to be aimed at only a handful of people.
Given   its  unique   orientation,  this   book  complements
virtually any other book on derivatives published so far.
Even in the one chapter on derivatives pricing the reader
will hardly find any overlap with other books. Basically,
this is the book that everybody should read before picking
up any other more technical book on the pricing and hedging
of derivatives.

Apart from the well-known Black-Scholes-Merton formula there
are no complex pricing formulas or numerical procedures to
be found in this book as we concentrate on derivative
product design and not pricing. Prices are thought to come
from a derivatives firm's trading desk, calculated using a
pricing framework more or less typical for those used by the
major derivatives firms. This emphasizes that derivatives
structuring is first and foremost 'financial architecture'
and not 'financial engineering'. The financial engineer only
comes in when the structuring process yields products that
the derivatives firm has not traded before. Given the
enormous progress which financial engineers have made over
the last decade, however, most structuring nowadays can be
done without having to fall back on a financial engineer.
The emphasis on intuition and common sense rather than
complex formal results makes this book accessible to people
with a large variety of backgrounds. Despite the fact that
there are more than 400 equations in the book, highschool
math will prove to be more than sufficient.

Because there is very little written on the actual
structuring of derivatives this book is not an overview of
the available literature nor is it a collection of
previously published articles. Instead of teaching the
reader a little bit of everything but not enough of
anything, the aim of this book is to teach the reader a
profession. The book can be used as a reference guide on a
multitude of issues long after reading it for the first
time. Moreover, although we restrict ourselves to equity
derivatives, the approach advocated works for any type of
derivative irrespective of the reference index used. Exactly
the  same   approach  we   use  here  to   structure  equity
derivatives can be used to structure interest rate, FX,
commodity, credit, energy, catastrophe derivatives, etc.

The book is made up of two parts. In the first part, which
covers chapter 1-5, we introduce the general philosophy and
the derivatives structurer's toolbox. In chapter 1 we
present our cash flow based approach to derivatives
structuring. The approach is extremely general. It is not
restricted to equity derivatives but can be used to
structure any kind of financial product. In chapter 2 we
discuss the equity market indices, the most common reference
indices for equity derivatives. We discuss how they are
calculated as well as how they have behaved over the last 10
years. Chapter 3 deals with the various rights and
restrictions that can be found in derivatives contracts. We
discuss so-called knock-in and knock-out features in quite
some detail as they have become one of the most popular
extras in derivatives contracts. In chapter 4 we discuss
index-linked cash flows. This chapter provides an overview
of most of the cash flow structures that are around
nowadays. In chapter 5 we discuss how derivatives firms
price derivatives contracts. A detailed treatment of this
subject would fill a book by itself. There are, however, too
many of them around already so we keep the discussion quite

In the second part of the book, which covers chapters 6-13,
we use the approach and tools developed in chapter 1-5 to
solve a large variety of real-life problems. In these
chapters it will become clear that for a derivatives firm
there are two ways to sell derivatives. First, it can
structure    derivatives   as   cheaper,   more   efficient
alternatives   to  traditional  cash  market  transactions.
Second, it can structure derivatives contracts which allow
end-users to do things that would not have been possible
otherwise. Of course, to do this successfully one must
thoroughly understand the relevant goals and restrictions.
In chapter 6-8 we investigate how equity derivatives can
help    institutional investors like mutual funds, hedge
funds, pension funds and life insurance companies. In
chapter 6 we investigate how equity derivatives can help
institutional investors to improve efficiency by reducing
operational and transaction costs as well as by avoiding
undesirable regulatory and fiscal effects. In chapter 7 and
8 we study how equity derivatives can be used to tailor the
payoff of an investment portfolio to the specific views and
preferences of its manager. We look at general asset
allocation strategies as well as the timing of market entry
and market exit.

Over the last five years stock market investing has gained
substantially in popularity among retail investors. Apart
from stocks or mutual funds, many retail investors have
bought specially designed equity-linked investment and
savings products. Most of these products, which have become
extremely popular with retail investors in Europe, can be
classified as so-called equity-linked notes. In chapter 9-12
we discuss the structuring and pricing of equity-linked
notes in great detail. There are two reasons why we spend
four chapters on this subject. First, it allows the reader
to see a large number of worked out examples. This does not
only provide a valuable overview of the different types of
notes and options around but also with what might be called
'synthetic experience'. Second, equity-linked notes are the
ideal platform to justify the existence of exotic equity
derivatives. Although derivatives firms would like us to
believe otherwise, the bulk of the more exotic contracts
traded in the market ends up in equity-linked notes and
similar equity-linked products. In chapter 13 we turn to
products designed for investors that want equity exposure
but do not have enough money available to actually buy
stocks or equity-linked notes. We discuss in detail how such
equity-linked savings products are structured as well as
their pricing and marketing. Following chapter 13, the
reader will find an overview of the major stock market
indices in the world, a brief glossary of the option
contracts discussed in the book as well as a very extensive

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