Pali Global Derivatives

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Pali Global Derivatives

• Exploiting Volatility as a Tool for Practical
  Risk Management

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Contact Information
Pali Capital, Inc. 650 Fifth Avenue New York, NY
10019 Tel. [phone] Fax [phone] Pali
International 6 Duke Street, St. Jamess London,
England SW1Y 6BN United Kingdom Tel. 44 (0)20
7190 0826

• Richard Anthony
• Senior Managing Director
• Head of Global Derivatives
• Email ranthony_at_palicapital.com
• Michael Palazzi
• Managing Director
• Head of Global Derivatives Sales
• Email mpalazzi_at_palicapital.com
• Ross McMeekin
• Global Derivatives
• Email rmcmeekin_at_palicapital.com

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The More Things Change The More They Stay The
Same

• A Quick Look at the VIX Index Over the Past 12
  months..
• (through 6/11/08)
• The 12-month Average .
  22.17
• High (1/22/08)...37
  .57
• Low (6/15/07)12.58
  
• of Times (Trading Days) the VIX reverted to the
  average 16
• The concept meets the test of time the 10-Year
  Average.20.53
• Source Bloomberg

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VIX01/11/08 02/09/09
Source Bloomberg
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Overview OTC vs. Exchange-traded Derivatives
(Equity, Index and ETF)

• Over-the-counter (OTC) derivatives are contracts
  that are traded (and privately negotiated)
  directly between two parties, without going
  through an exchange or other intermediary. The
  OTC derivative market is the largest market for
  derivatives, and is unregulated. Reporting of OTC
  amounts are difficult because trades can occur in
  private, without activity being visible on any
  exchange. OTC derivatives are largely subject to
  counterparty risk, as the validity of a contract
  depends on the counterparty's solvency and
  ability to honor its obligations.
• Exchange-traded derivatives are those derivatives
  products based on standardized terms that are
  traded via an exchange. A derivatives exchange
  acts as an intermediary to all related
  transactions, and takes Initial margin from both
  sides of the trade to act as a guarantee. Primary
  exchanges for equity, index and ETF derivatives
  in North America include Montreal, ISE, CBOE
  (Chicago), Philadelphia, AMEX, Pacific, etc.
  Counterparty risk is transferred to an
  institutional intermediary, (Example The OCC,
  Options Clearing Corporation) or other central
  clearinghouse to facilitate clearing and
  assignment issues, etc
• Given their unique risk-reward profile, the focus
  of our discussion today will be on the use of
  exchange-traded options as the preferred tool for
  managing risk and enhancing returns.

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• Advantages and Uses of the Exchange-traded option
• Market liquidity
• Transparency intraday price discovery and daily
  marks to market
• Lower execution and processing costs
• Breadth of asset class exposures attainable
  (index, stock, sector, geographic region,
  commodity, etc)
• Mitigation of counterparty risk in an option
  trade
• Source of portable alpha the Non-linear,
  non-correlated return profile, facilitating
  multiple portfolio objectives (dynamic hedging,
  directional's, etc).
• Introduction to a new discipline Greek
  Optimization approach to effectively harness
  volatility as an asset class, by capturing
  fluctuations in the volatility skew.
•  
• To Meet Your Specific Objectives
• Reduce risk
• Express a directional viewpoint
• Generate Income
• Facilitate pairs trades
• Create market-neutral exposures
• Summary Enhance the risk-adjusted returns for
  the portfolio

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Volatility A Quick Review

• Implied Volatility
• The implied volatility of an option contract is
  the volatility implied by the market price of the
  option based on an option pricing model. In other
  words, it is the volatility that, given a
  particular pricing model, yields a theoretical
  value for the option equal to the current market
  price. Implied Volatility can be measured for a
  specific underlying security, or across a broader
  measure of the market, such as the VIX Index.
• Historical (Realized) Volatility
• Historical Volatility refers to the standard
  deviation of the change in value of a financial
  instrument with a specific, observed time
  horizon. It is often used to quantify the risk of
  the instrument over that time period. Volatility
  is typically expressed in annualized terms as a
  percentage and it can be traded directly in
  today's markets through options.
• Measuring Market Volatility
• Today, several broad market measures of implied
  volatility are available, enabling you to track
  the implied volatility across several markets.
  The most widely followed benchmark is the VIX
  index (based on the SP 500) with history
  beginning in 1990. See the WVI screen on
  Bloomberg to track the available volatility
  indices on the Nasdaq 100, Russell 2000, and
  several European benchmarks, like the DJ
  Eurostoxx, DAX, CAC etc.

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Inverse Correlation A 15-year Comparison of the
VIX vs. SP 500
Source Bloomberg
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Monetizing the Volatility Skew

• The Volatility Skew
• Against this back-drop of the broader measures
  of volatility seen in the marketplace, we can
  make a more meaningful interpretation of the
  implied volatility exhibited by a single security
  (Ex single stock, or ETF).
• The volatility skew is defined as the difference
  in the implied volatility of the out-of-the-money
  puts vs. the out-of-the-money calls over a
  specific interval. This skew is a constant state
  of flux, and expands in periods of greater
  uncertainty (as price falls), and contracts in
  periods of complacency (as price rises). Hence,
  by exploiting this ever-changing expansion and
  contraction of the volatility skew - the
  volatility of volatility we reap the advantage
  of the Optimization Process.
• Practical Application
• By applying an active management approach to the
  underlying volatility, we also benefit from the
  inherent diversification from this component in
  our portfolio, as seen from negative correlations
  between the volatility of the asset and the
  underlying asset itself.

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An Illustration of the Volatility Skew SP 500

Source Bloomberg
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Harnessing Volatility Key Concepts

• Historical Volatility Mean Reversion
• One of the Key Concepts to understand with the
  goal of exploiting the volatility of volatility
  is that volatility itself is a mean-reverting
  measure. Although historical volatility is always
  in a state of change, most stocks or indexes can
  be assigned a normal or average value. When
  volatility diverges greatly from that normal
  range, there is tendency for it to revert back to
  the average, or mean, thereby creating an
  opportunity to exploit the anticipated movement
  in these periods.
• Option Pricing the Impact of Non-linearity
• Because the pricing of options depends on so
  many different variables, there is a non-linear,
  non-correlated relationship between the pricing
  of options and the underlying instrument. A
  resulting option structure can be designed to
  express the viewpoint of the fund manager in a
  manner that provides the potential to outperform
  the underlying shares, by harnessing the power of
  the 4 key moving parts within the option delta,
  gamma, vega, and theta.

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Structuring the Appropriate Exposures Know Thy
Greeks

• Delta
• How the option structures PL will be affected
  by a one point move up or down in the underlying
  security.
• Gamma
• The rate of change of Delta What the new Delta
  will be after a one point move up or down in the
  underlying. Gamma is the velocity or
  conviction Greek. All structures will have a
  different Gamma effect, whether the underlying
  goes up (upside gamma), or down (downside gamma).
• Vega
• How the option structures PL will be affected
  by a 1 point increase or decrease in implied
  volatility
• Theta
• How the option structures PL will be affected
  by overnight time decay, including holidays and
  week-ends.

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Incorporating Option Structures to Enhance
Risk-adjusted Returns

• We look at all option structures as having two
  unique stages of development
• The initial structure or "opening salvo" is
  determined by the client articulating their
  viewpoint to us and in a collective process the
  mathematically first optimal structure is agreed
  upon. We then execute the structure on behalf of
  the client, acting as agent.
• Once the initial structure is executed, the focus
  remains on pro-active monitoring of each
  structure, to maintain the desired exposures
  while taking advantage of the fluctuations in the
  underlying portfolio to improve the risk-reward
  profile over time. This is the essence of the
  Greek Optimization methodology.
• The ultimate goal of the optimization process is
  to improve the structure's units of reward per
  units of risk. In this manner, the option
  structure can be employed to fulfill multiple
  objectives beyond the core objective for dynamic
  hedging.

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From Concept to ExecutionTracking Exposures and
Performance with Bloomberg's Option Scenario
Analysis (OSA)
Source Bloomberg
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GLD Option Structure vs. Common Shares

• Trade executed 2/5/09 with GLD _at_
  89.45 Notional 118,500,000
• Delta 1,306,500
• Sold 37,500 Sep 74 puts _at_ 3.8267 Gamma -38,500
• Bot 25,000 Sep 88 calls _at_ 12.565 Vega -946,700
• Sold 37,500 Sep 125 calls _at_ 4.3167 Theta 95,500

Option Strategy on Expiry (09-18-09) Common Shares
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• The strategies mentioned here may help to
  decrease the risk on your investments, however,
  they may also limit the upside potential of your
  investments. For more information regarding these
  risks, please contact us. Options involve risk
  and are not suitable for all investors.  Prior to
  investing in listed options, you should read and
  understand the Options Disclosure Document
  ("ODD") published by the Options Clearing Corp. 
  For a copy of the ODD, please click the following
  link to download from the OCC's
  website.http//www.optionsclearing.com/publication
  s/risks/riskchap1.jsp