Ratchet Options – Study Guide PDF

Preview

Summary

Study Guide of ratchet options - summary of module information on ratchet options...

Description

Ratchet Options – Study Guide A Ratchet/Cliquet Call option is nothing more than a ‘strip’ or series or portfolio of forwardstarting options which reset ATM to prevailing spot price St at fixed pre-determined future points in time t>0 (but with the BIG difference that the payouts on the forward-starting calls are delayed until the maturity of the ratchet). When to use ratchet options? When you have a steady bull outlook on the market: see it rising steadily for next three years, for example, coming off a phase of high short-term volatility. Are cheapest when ‘forward volatility’ (future estimations of volatility is low, i.e coming off of high short-term volatility). Due to the fact that volatility has a positive has a positive correlation with share price deviations and a positive correlation with call price. Have moderately positive and steady outlook on price of the underlying/basket. Example: 3Y 100% ratchet call on BMW Ratchet call locks-in the upside performance (if any) of BMW at the end of each year. In other words, the strike price of the underlying call “resets” at the end of each year to the prevailing price of a BMW share, while locking-in any upside gain over the year which has jst elapsed. Say: So =40 St1 =45 St2=50 St3= 45, then the ratchet call locks-in (and defers pay-out until end of Yr3), expiring option payoffs as follows:   

Max [(ST1=45) – (X=40), 0] = 5 payment (deferred 2 yrs to end of Yr3) Max [(St2=50)- (X=45),0]= 5 payment (deferred 1 yr to end of Yr 3). Max [(St3=45)-(X=50),0] = 0 (payment immediately at end of Yr 3).

The 3Yr Ratchet Call option is comprised of the following portfolio of spot and forwardstarting call options : (European-exercise only on dates Y1, Y2 and Y3). 1) A spot-starting 1Y ATM call option which starts immediately, matures at end of Y1 and has a pay-out delayed until end of Y3 (i.e pay-out delayed by 2 Yrs). 2) A forward starting 1Y ATM call option which starts at beginning of Y2, matures at end of Y2 and has a pay-out delayed until end of Y3 (i.e pay-out delayed by 1Yr). 3) A forward-starting 1Y ATM call option which starts at beginning of Y3 and matures at end of Y3.

Coupons payable at end of each year over the interval Y3-Y5 are locked-in equal to the annualised performance of the basket, subject to an upper cumulative cap of 10%. Therefore, the coupon payable at the end of the n-th year Cn is given by: Cn= min [0.1, max (0, (sn/100) *1/n -1)]

Formula though mathematically correct, does not explain: 1) How annual returns (as long as they are below 10% CAR since launch) – are linked to the performance of the underlying basket-can be “locked-in” each year, starting in yr 3. 2) How the investor’s upside exposure can be “knocked-out” at any time commencing in Yr 3 if the basket-linked annualised return (i.e CAR) since launch exceeds 10%. The knock-out feature (as with a Cap or the sell OTM call leg –c in a collar = +F-C+P) makes the ratchet call option considerably cheaper to purchase than an otherwise identical forward-starting 5 Year ratchet, since it caps the probability of the investor receiving “bluesky” returns from extremely positive performance of the underlying basket above the barriers, and makes full (100%) participation in the performance of the underlying basket more affordable.    

Spoken in terms of ‘locking-in’ annualised returns as a coupon. Floors and caps are included to limit exposure (both +ve and –ve) Marketed as a structured investment product Incorporating a cap/floor of 0%/100%, the ‘coupon’ Cn is given by: Cn=min[0.1, max(0, (sn/100)*1/n – 1)].

Example: presume 10% increase EoY1, further 5% increase E0Y2.  100 x 1.1 (Yr1) x 1.05 (Yr2) = 115.5 CAR=

(

)

115.50 12 −1 =0.074709 100

=7.47%  7.47% is the (geometric) annualised compound rate of return, a.k.a cumulative coupon....