An equity derivative is a financial product whose payoff is derived from an underlying equity or a basket of equities or an equity index. Investors and traders can use equity derivatives to take a long or short position in a stock without actually buying or shorting the stock. This is advantageous because taking a position with derivatives allows the investor/trader more leverage in that the amount of capital needed is much less than a similar outright long or short position on margin. Investors/traders can therefore profit more from a price movement in the underlying stock.
Equity derivatives provide investors a way to hedge risk or speculate. Also option trading can limit an investor’s risk and leverage investing potential. Derivative investors have a number of strategies they can utilize, depending on risk tolerance and expected return.
The following products are most heavily traded in the equity market.
1. Equity Futures
An Equity Futures contract traded over an organized exchange. In this contract parties commit to buy or sell a specified amount of an individual stock or a basket of stocks or a stock index at an agreed contract price on a specified date. Generally there are two types of Equity Futures: Index Future and Stock Future. Stock markets Index Futures are futures contracts used to replicate the performance of an underlying stock market index. They can be used for hedging against an existing equity position, or speculating on future movements of the index. Indices for futures include well-established indices such as S&P 500, FTSE 100, DAX, CAC 40 and other G12 country indices. Indices for OTC products are broadly similar, but offer more flexibility.
2. Equity Swap
An equity swap is an agreement where one party makes payments based on a set rate, either fixed or variable, while the other party makes payments based on the total return of an equity, a basket of equities, or an equity index. Equity swap is a good vehicle for counterparties to transfer risk. One party makes cash payments based on a predefined fixed or floating rate, whereas the other party makes payments based on the total return of an underlying asset. The party receiving the total return gains exposure to the performance of the reference underlying asset without actually owning it. Therefore, this product can be used to obtain a leveraged exposure. On the opposite of the transaction, the counterparty receive payments of a reference interest rate payments that provide some protection against a potential loss of the underlying asset.
3. Correlation Swap
A Correlation Swap is an instrument where the option buyer receives the difference between the observed correlation and the strike correlation on a basket of assets, observed over a specified time interval. It can be thought of as a forward contract on realized correlation. Its payoff is simply the difference between the realized correlation over the stated period and the strike times the notional of the contract
4. European Option
An European options give an investor the right but not the obligation to buy a call or sell a put at a set strike price prior to the contract’s expiry date. European options are derivatives that means their value is derived from the value of an underlying equity.
European options provide investors a way to hedge risk or speculate. Also option trading can limit an investor’s risk and leverage investing potential. Option investors have a number of strategies they can utilize, depending on risk tolerance and expected return.
5. American Option
American options provide investors a way to hedge risk or speculate. Also option trading can limit an investor’s risk and leverage investing potential.
Stock option investors have a number of strategies they can utilize, depending on risk tolerance and expected return. Buying call options allows you
to benefit from an upward price movement. The right to buy stock at a fixed price becomes more valuable as the price of the underlying stock increases.
Put options may provide a more attractive method than shorting stock for profiting on stock price declines. If you have an established profitable long stock position, you can buy puts to protect this position against short-term stock price declines. An option seller earns the premium if the underlying stock price would not change much.
6. Asian Option
Asian options allow the buyer to purchase (or sell) the underlying asset at the average price instead of the spot price. Asian options are commonly seen options over the OTC markets. Average price options are less expensive than regular options and are arguably more appropriate than regular options for meeting some of the needs of corporate treasurers. Average can be calculated in a number of ways (daily, weekly, monthly, etc.).
7. Basket Option
A basket option can be used to hedge the risk exposure to or speculate the market move on the underlying stock basket. Because it involves just one transaction, a basket option often costs less than multiple single options. The most important feature of a basket option is its ability to efficiently hedge risk on multiple assets at the same time. Rather than hedging each individual asset, the investor can manage risk for the basket, or portfolio, in one transaction. The benefits of a single transaction can be great, especially when avoiding the costs associated with hedging each and every component of the basket or portfolio.
8. Digital Option
A digital option is an option with a predetermined payoff, triggered only if the underlying price meets the strike price. These are also commonly referred to as “all or nothing”. Digital call pays a fixed amount if the underlying price ends up above the strike price, while binary put pays off a fixed amount if the underlying price is below the strike price at option maturity.
9. Quanto Option
Quantos are attractive because they shield the purchaser from exchange rate fluctuations. If a US investor were to invest directly in the Japanese stocks that comprise the Nikkei, he would be exposed to both fluctuations in the Nikkei index and fluctuations in the USD/JPY exchange rate. Essentially, a quanto has an embedded currency forward with a variable notional amount. It is that variable notional amount that give quantos their name—”quanto” is short for “quantity adjusting.”
Warrants frequently attached to fixed rate bonds or preferred stock as a sweetener can be used to enhance the yield of the fixed rate bond and make them more attractive to potential buyers. Most commonly issued warrants are often detachable, meaning that they can be separated from the fixed rate bond and sold on the secondary market before expiration. Wedded or wedding warrants are not detachable. The investor must surrender the fixed rate bond or preferred stock the warrant is “wedded” to in order to exercise it. Naked warrants are issued on their own, without accompanying fixed rate bonds or preferred stock.
11. Variance Swap
A Variance Swap contract has a payoff which is dependent on realized variance. In order to calculate the fair value of future delivery variance, the variance swap can be replicated by a forward contract and a portfolio of appropriately weighted European call and put options with a continuous range of strikes. This continuous spectrum of options is not observable and hence a (finite) discrete approximate replication must be performed in practice.
12. Convertible Bond
Convertible bonds typically have lower yields than the yields on similar fixed rate bonds without the convertible option. Reverse convertible bonds usually have shorter terms to maturity and higher yields than most other fixed rate bonds.
Most convertible bonds are subordinated debt of the issuer. In the event of bankruptcy, the claims of other bondholders take priority over convertible bondholders, who themselves have priority over owners of the preferred and common stock.
13. Lookback Option
Lookback options are designed to provide investors with the opportunity for an enhanced return while reducing the downside risks with partial protection that “buffers” any negative performance of the Reference Index over the term of the Notes. The “look-back” feature offers holders an optimal entry point for their investment.
14. Barrier Option
There are two types of contracts, knock-in barrier options and knock-out barrier options, each respond differently when the barrier is “triggered”. If a knock-out option’s underlying touches the barrier, the option is eliminated and the holder receives a rebate. Conversely, a knock-in option touches the barrier to activate the option. If the knock-in option never reaches the barrier, the holder will receive a rebate.
15. Cliquet Option
Cliquet options are widely traded in many retail-structured products. They consist of financial derivatives which provide a guaranteed minimum return in exchange for a capping of the maximal return over the life of the contract. A cliquet option is equivalent to a series of forward-starting at-the-money options, which may be globally and locally floored and capped. .
Cliquet options are appealing to investors because they can protect themselves against downside risks. Possible variants include reverse cliquet which amounts to a cash flow minus a capped cliquet of puts, and digital cliquet, where the forward-starting options are digital options.
16. Spread Option
The use of spread options is widespread for speculation, basis risk mitigation, or even asset valuation. Spread options allow investors to simultaneously take positions in two are more assets and profit from their price difference over some spread.
Because of their generic nature, spread options are used in markets as varied as equity markets, fixed income markets, currency and foreign exchange markets, commodity futures markets, and energy markets.
17. Callable Notes
A callable note allows the issuer to exercise a call option on the note on a specified date or set of dates prior to maturity. Callable note is among the most challenging derivatives to price. These products are loosely defined by the provision that the holder or issuer has the right to call the product or exercise into various underlying instruments after a lock-out period expires.
18. Best/Worst of Option
Best of Option or Worst of Option is a chooser option that returns the best/worst performing among several baskets of funds or indices that reflect growth, moderate and conservative investment styles. The returns could be based on average (Asian), single currency or quanto. The final payoff could be capped and floored.
19. Rainbow Option
Rainbow options are appealing to investors due to its natural risk diversification, cost efficiency, and weighted average on the best or worst performing assets. The best version offers higher returns, whereas the worst version is normally cheap.
20. Callable Range Accrual Note
A callable range accrual note contains an embedded option that allows the issuer to exercise a call on the note on a particular date or set of dates prior to maturity. This can be used by the issuer to limit the return that is paid to the note holder. On these exercise dates, the issuer may purchase the note back from the holder for a predetermined cash amount, which is typically equal to or greater than the face value of the note.
21. Reverse Convertible Autocallable Swap or Bond
A reverse convertible autocallable swap allows two parties exchange floating coupons with fixed coupons on certain future dates. On some coupon dates, the swap may be cancelled. Should the swap be cancelled on coupon date t, the coupons due on coupon date t will be paid and all further cash flows are terminated.
A reverse convertible bond is a bond with an embedded put option that allows the issuer to purchase the note back for a predetermined quantity of cash, debt, or stock. The decision to exercise the option is made based on the performance of an underlying asset, index, or basket of assets.
22. Callable Yield Note
Callable yield note usually pays a higher coupon or interest rate to investor. However, the event of the call of the note is uncertain to the investor. It is note only linked to the level of a basket of underlying assets, but also to volatility, correlation, dividends, and yield curve.
23. Accelerated Return Note
An Accelerated Return Note (ARN) is a structured instrument that offers a potentially higher return linked to the performance of a reference entity that could be an equity, an index, or a basket of assets. The payoff depends on the performance of the underlying assets. Usually, it is capped but not floored, that means it does not offer any downside protection.
24. Autocallable Note
Autocallable notes offer a coupon that is higher than regular fixed rate bond. It is suitable for investors who are seeking enhanced yield opportunities. Auto-call investments provide a contingent downside protection that protects the principal as long as the reference asset has not traded below the downside barrier.
25. Constant Proportion Portfolio Insurance (CPPI)
A constant proportion portfolio insurance (CPPI) is a trading strategy where an initial investment is dynamically reallocated between a risky asset and risk-free bond such that a minimum payoff is guaranteed at maturity. The risky asset could be from equities, funds, or commodities.
26. Accelerated Share Repurchase
An accelerated share repurchase (ASR) agreement is a contract or an investment strategy used by a publicly traded company to buy back shares of stocks expeditiously from the market. In these agreements, firms are able to repurchase a significant number of their shares upfront. The intermediary must then repurchase the shares over a given time window that is equivalent to enter into a forward contract.
27. Equity-Linked Bonus Coupon Note
A bonus coupon note, also referred to as coupon growth note or bonus enhanced note or basket coupon note, is an equity-linked note that provides guaranteed coupons over the life of the note with potential for a bonus coupon based on the underlying asset trading above a specified barrier level.
The note pays a series of coupons based on the weighted performance of all assets in the basket on each Coupon Determination Date. The coupons are usually capped and floored.
28. Himalaya Option
A Himalaya option is an option on the sum of the returns of the best (worst) performing assets from a basket on predefined observation dates. It has a set of observation dates are defined. The number of observation dates are equal to the number of underlying assets. The unique feature of Himalaya option is the withdrawal of the best performer asset from the basket at each pre-defined observation date, until only one stock remains.