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Outperformance Options
Catley Lakeman Winter Offsite – January 2014
Introduction
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Country/region specific views can be implemented via outperformance options.
Within regions, general equity sub-sectors can be included - e.g. Mid Cap versus Large
Cap
Examples of Outperformance Notes include;
Europe over US (or vice-versa)
EM over DM (or vice-versa)
Mid cap over Large cap (or vice-versa)
Exposure to the performance of one index over another (including in the case of both
indices falling)
“Relative Allocation”
Description
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Outperformance is the difference in relative performance of one asset over another.
This is defined as the percentage change since the initial level which is set at the outset of the trade.
I.e. Day 1 both indices are at 100% of their initial level, by definition.
Dec-01 May-03 Sep-04 Feb-06 Jun-07 Nov-08 Mar-10 Jul-11 Dec-12
-70%
-60%
-50%
-40%
-30%
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0%
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20%
30%
FTSE 100 Index Local Currency 5Y Performance - S&P 500 Index Local Currency Performance Spread
S&P outperforms FTSE in these periods
FTSE outperforms S&P in these periods
Pricing Factors of Outperformance Options
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These are the main factors which the price of an outperformance option can be
attributed to, there are others.
The Forwards of the two Indices - the difference between the two forwards is
an important factor.
Volatility
Correlation
Forwards
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Forward Factor Differential
Date Index Current Spot Rate DivYield Forward Factor 5 year Forward
11/12/2013 FTSE 100 6507.72 1.84% 3.62% 91.48% 5953.35
11/12/2013 S&P 500 1782.22 1.60% 2.15% 97.31% 1734.32
Difference -5.83%
Remember: Rates minus Dividends
The Forward of the S&P 500 is greater (5.83%) than that of FTSE 100.
Locking in current forward levels!
Price of an outperformance option of FTSE100 over S&P 500 will be cheaper than that of S&P over
FTSE 100
Outperformance option quotes – *Indicative Composite Quotes
Date Index Price Tenor
11/12/2013 FTSE 100 over S&P 500 6.24% 5 year
11/12/2013 S&P 500 over FTSE 100 12.44% 5 year
FTSE 100...11.4%
S&P 500...15.5%
Vanilla Call premiums (in local crncy)?
Volatility of the Underlyings
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Most circumstances: an increase in Implied Volatility for either of the underlyings results in an
increase in the value of an outperformance option
Why? → Remember we have a call option on the spread of the performance between
two indices, the increase in the volatility of that spread will cause the value of the
option to also increase (most cases) → “Positive Vega”
The blue line shows an increasing volatility regime, this results in the spread between the indices increasing in volatility
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FTSE 100 simulationS&P 500 Simulationvol of spread
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Vol of FTSE 100 is 18.1%Vol of S&P 500 is 19.5%
Simulated Correlation = 0.81 throughout
Vol of FTSE 100 increases 28.1%Vol of S&P 500 remains at 19.5%
The blue line shows an increasing volatility regime, this results in the spread between the indices increasing in volatility
Volatility of the Underlyings
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Other circumstance: High correlation, volatility collapse of one of the indices can lead to an
increase in the value of an outperformance option
Why? → again, the result here is an increase in the volatility of that spread. Example
given below
Both indices move in sympathy (high correlation) but with differing volatility, volatility of the spread is higher.
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FTSE 100 simulationS&P 500 Simulationvol of spread
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Vol of FTSE 100 is 18.1%Vol of S&P 500 is 19.5%
Simulated Correlation = 0.93 throughout
Vol of FTSE 100 remains 18.1%Vol of S&P 500 decreases to 9.8%
Both indices move in sympathy (high correlation) but with differing volatility, volatility of the spread is higher.
Correlation of the Underlyings
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Investors are “short” Implied Correlation between the two indices – i.e. investors benefit from the fall
in the implied correlation of the performance of the two indices.
Why? → again, the result here is an increase in the volatility of the spread. Example
given below
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FTSE 100 simulationS&P 500 Simulationvol of spread
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Correlation = 0.95
Correlation = 0.48
Markets move in a less correlated way... Again, look at the effect on the spread volatility
Fall in Correlation
Correlation of the Underlyings
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Investors are “short” Implied Correlation between the two indices – i.e. investors benefit from the fall
in the implied correlation of the performance of the two indices.
Why? → again, the result here is an increase in the volatility of the spread. Example
given below
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How different correlations affect the price of an Outperformance option
Correlation of Indices
Example:Both indices at 100, Vol(A) = Vol(B) = 20%, 1 year to expiry
©Tom May
Outperformance Note Indicative Prices – UK and US
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Dec-01 Sep-04 Jun-07 Mar-10 Dec-12
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FTSE 100 Index Local Currency 5Y Per-formance - S&P 500 Index Local Cur-
rency Performance Spread
S&P outper-forms FTSE in these periods
FTSE out-performs S&P in these periods
5Yr UBS FTSE over S&P Outperformance Note
GBP quanto
262% Participation in any outperformance of
FTSE over S&P after 5 year term
Soft capital protection, 60% knock-in , worst-
of.
[Cap protected version: 115% participation]
5Yr UBS S&P over FTSE Outperformance Note
GBP quanto
145% Participation in any outperformance of
S&P over FTSE after 5 year term
Soft capital protection, 60% knock-in , worst-
of.
[Cap protected version: 56% participation]
Initial Sensitivities
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Initial sensitivities of the trade (version with soft capital protection):
5Yr UBS FTSE over S&P Outperformance Note
GBP quanto
262% Participation in any outperformance of FTSE over S&P after 5 year term
Soft capital protection, 60% knock-in , worst-of.
[Cap protected version: 115% participation]
Sensitivity
...to the underlying Spot moves FTSE 100: 138.1% note positiveS&P 500: -77.4% note negative
Net Delta: 60.7%
...to the change in implied Volatility FTSE 100: -0.29%S&P 500: 0.39%
Net Vega: 0.1%
Initial Sensitivities
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Initial sensitivities of the trade (version with soft capital protection):
5Yr UBS FTSE over S&P Outperformance Note
GBP quanto
262% Participation in any outperformance of FTSE over S&P after 5 year term
Soft capital protection, 60% knock-in , worst-of.
[Cap protected version: 115% participation]
Sensitivity
...to the Correlation between the underlyings
Outperformance options:-0.77% per correlation point
Worst-of KI Put option:+0.17% per correlation point
Net = -0.60% per correlation point
Sensitivity to correlation is at a maximum when both index volatilities are equal
Initial Sensitivities
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Initial sensitivities of the trade (version with soft capital protection):
5Yr UBS FTSE over S&P Outperformance Note
GBP quanto
262% Participation in any outperformance of FTSE over S&P after 5 year term
Soft capital protection, 60% knock-in , worst-of.
[Cap protected version: 115% participation]
Sensitivity
...to the change in interest rates Assuming a 1% move in both USD and GBP rates -2.6% per +1% rate move
Outperformance Note Indicative Prices – EM and DM
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5Yr UBS EEM UP over S&P 500 Outperformance
Note
GBP quanto
112% Participation in any outperformance of
EEM UP over S&P 500 after 5 year term
Soft capital protection, 60% knock-in , worst-
of.
5Yr UBS S&P 500 over EEM UP Outperformance
Note
GBP quanto
135% Participation in any outperformance of
S&P 500 over EEM UP after 5 year term
Soft capital protection, 60% knock-in , worst-
of.
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EEM UP Equity Local Currency 5Y Per-formance - S&P 500 Index Local Cur-
rency Performance Spread
S&P outper-forms EEM UP in these periods
EEM UP outperforms S&P in these periods
Outperformance Note Indicative Prices – Mid and Large Cap
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5Yr UBS S&P 400 Midcap over S&P 500
Outperformance Note
GBP quanto
160% Participation in any outperformance of
S&P 400 Midcap over S&P 500 after 5 year
term
Soft capital protection, 60% knock-in , worst-
of.
5Yr UBS S&P 500 over S&P 400 Midcap
Outperformance Note
GBP quanto
234% Participation in any outperformance of
S&P 500 over S&P 400 Midcap after 5 year
term
Soft capital protection, 60% knock-in , worst-
of.
Jan-02 Oct-04 Jul-07 Apr-10 Jan-13
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MID Index Local Currency 5Y Perfor-mance - S&P 500 Index Local Currency
Performance Spread
S&P 400 Mid cap Index outperforms S&P in this historical backtest
Summary
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Forwards are very important – The benefit of locking in current forward levels is seen
in the large headline rate of FTSE 100 over S&P 500
Correlation and Volatility of each underlying combine to give the spread volatility
Allocation tailored to differing prospects between two indices (region-region, sector-
sector, etc.)
Gain increased exposure to performance of one index over another, with defined
downside
Summary
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Summary of sensitivities (generalised)
Delta: Positive the “out-performer”, negative the “under-performer”
Long volatility on the Outperformance Options, with the Knock-in, day 1 sensitivity
~neutral
Short correlation
The long vol exposure is likely to be dominant over the short correlation exposure.
Disclaimer
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is not subject to any prohibition of dealing ahead of the dissemination of investment research.
The information in this document is derived from sources believed to be reliable but which have not been independently verified. Any prices included within this
communication are for indicative purposes only. Catley Lakeman Securities makes no guarantee of its accuracy and completeness and is not responsible for errors of
transmission of factual or analytical data, nor is it liable for damages arising out of any person’s reliance upon this information. All charts and graphs are from publicly
available sources or proprietary data. The opinions in this document constitute the present judgment of Catley Lakeman Securities, which is subject to change without
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