Options on equity / share indices

The options on indices markets of the world are also large and active. Examples of indices are the FTSE 100 in the UK, the DJIA and the S&P 500 in the US, the ALSI and the INDI in South Africa. They are mostly exchange-traded, but an OTC market also exists.

An option on a share index allows the holder to take a position in the index (short or long) for the price of the premium quoted. This means that to buyer of a share index is buying the right to "invest" in a diversified portfolio (of the shares that make up the index) at a pre-specified price.

The size of index options is established by a multiplier applied to an index, i.e. the size of a share index option is equal to the index value (specifically the strike index value / price - SIV) times the multiplier. For example, the size of an option on the S&P 500 is = SIV x USD 500. In the case of the DJIAA it is SIV x USD 100. If for example the SIV on the S&P 500 = 1635, the size / exposure of the option = 1635 x USD 500 = USD 817 500. These options are settled in cash, obviously because the index cannot be delivered.

An example may be constructive here:58 An investor has a portfolio that he set up to replicate the S&P 500 share index. He is concerned that monetary policy is about to be tightened and that share prices are about to fall sharply, but he does not want to sell because it is expensive to sell and to reconstruct this portfolio again after the fall (because of brokerage, taxes, etc). The value of his portfolio is USD 2.8 million and the S&P 500 SIV of a 3-month put option = 1400. The size of each option is thus 1400 x USD 500 = USD 700 000. The investor will buy four 3-month put options on the S&P index. Thus the investor is hedging his USD 2.8 million portfolio with four put options = USD 2 800 000 (4 x USD 500 x 1400).

We assume that the investor is right in his view and the index over three months falls to 1120 (i.e. by 280 points or 20%). The value of the investor's portfolio will be USD 2.24 million (remember he replicated the S&P 500 index with "physical" shares), i.e. he incurs a loss of USD 560 00059. However, the investor exercises the four put options on expiry date, and makes a profit of:

(1400 - 1120) x USD 500 x 4 = USD 560 000,

which = the loss on his portfolio.

Equity / share warrants (call options)

As in the case of bond warrants, internationally equity / share warrants bestow the right (option) on the holder of the warrant to take up new shares of the relevant company. These call options are usually long term in duration.

Equity / share warrants (retail options)

In some countries a version of equity / share warrants (as in the case of bond warrants) exist: they are ordinary options (call and put options), but are small in size, i.e. retail. Exercising of a warrant does not lead to the issue of new shares of the relevant company. Warrants are also written on equity / share indices.

The retail warrants market has grown rapidly in recent years. Warrants comprise call and put options on specific shares and on certain indices. They are of the American and European varieties and are usually listed on the exchange. As such they are traded and settled via a stock broking broker-dealer firm. The issuers make a market in their equity warrants, i.e. quote bid (holder sells to the issuer) and offer (holder buys from the issuer) prices simultaneously, for example, bid: 12 cents / offer: 13 cents (these prices are called premiums).

The advantages of warrants are many. One of the issuers and market-makers lists eight as follows61:

1. Warrants enable investors to trade on the exchange with the same ease as trading ordinary shares.

2. Warrants offer a low cost entry into blue chip shares.

3. There is potential to leverage or gear up your investment.

4. Your risk is limited to the initial premium (price of the warrant) paid.

5. Warrants have the transparency of a listed instrument.

6. Small investors can short the market or hedge their portfolios through the use of put warrants and so profit from falls in the market.

7. The warrants market is extremely liquid, as the issuer is required to provide both bids and offers.

8. Warrants are an extremely cheap instrument to trade.

The risks associated with warrants are price risk and credit risk. However, as shown above, price risk is limited to the premium which is a fraction of the value of the relevant share; i.e. there is limited downside risk and marked upside profit opportunity. While settlement is guaranteed by the exchange, the holder takes on credit risk because the counterparty to the deal is the issuer. As seen, these are the larger banks; as such credit risk is deemed to be small.

As noted, warrants are written on specific shares, usually the high market capitalisation shares, and on certain indices. In addition to the "ordinary" equity warrants, there are a number of variations on the theme, such as reset warrants and knockout warrants.

Redeemable preference shares

Preference shares (also called "preferred stock") in many countries are like perpetual bonds in that they never mature: perpetual preference shares. In other countries they are required to be redeemable or redeemable at the option of the issuer.

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