Trends and Uses of Equity

Derivatives
Presentation to 3rd Hedge Fund
Conference, Milan

Mickey de Lathauwer
Massoud Mussavian

1
Trends, Responses and Implications

I. Recent trends in global markets

II. How have investors responded?

III. What does it mean for your investment process?

2
I. Recent trends in global
markets

3
Trends

Recent big trends in global markets

1. Higher equity volatility

2. Lower diversification within equities

3. Negative correlation of equity and bond returns

4
Trend 1: Higher Equity Volatility

Equity volatility is at high historical levels

S&P 500 Daily Realized volatility 1929-Present
80

70

60

50
Volatility (%)

40

30

20

10

0
1929 1939 1949 1959 1969 1979 1989 1999
3 Mth Realised Volatility

Source: FAME

5
Trend 1: And Equity Markets Feel More
Volatile
Because higher risk has meant more negative returns

Last Prior S&P Stock Risk Deciles

24 Months 5 Years Return and Risk
S&P 500 Volatility 24.5% 18.1%
% Months 70 1998-1999
S&P Returns < -5% 37.5% 6.7%

Annualized Return
50
30
10
-10
2000-2001
-30
2002
-50
20 30 40 50 60 70
Annualized Volatility (Weekly Returns)

Source: FAME

6
 Trend 1: And volatilities are volatile

The range within which volatility trades is also at extreme levels

55%
55%
DAX FTSE
50%
50%

45% 45%

40% 40%

35% 35%

30% 30%

25% 25%

20% 20%

15% 15%

10% 10%
1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

Source: FAME

7
Trend 2: Diversification Within Equities Has
Decreased
The benefits of diversification within equities has fallen
Implied Correlations
1.0
STOXX50E DAX SP500

0.8

0.6

0.4

0.2
Mar-01 Jun-01 Sep-01 Dec-01 Mar-02 Jun-02 Sep-02 Dec-02 Mar-03

Source: Goldman Sachs, FAME

8
Trend 3: Equity and Bond Returns
are Negatively Correlated
12 mth Rolling S&P 500 / Long-
Long-term Government Bond Correlation

1.00

0.75

0.50

0.25

0.00

-0.25

-0.50

-0.75

-1.00
1953 1963 1973 1983 1993 2003

Source: Goldman Sachs and Ibbotson Associates

9
II. How have investors
responded?

10
Responses

Investors have responded to the trends by

1. Reducing or hedging equity exposure

2. Reducing active risk
3. Using more index products
4. Looking for alternative sources of alpha

This increases the importance of derivatives in markets:

n Price discovery and leadership in derivative markets

n Risks transferred from one asset class to another

11
 Response 1: Reduce or hedge equity
exposure
Hedging equity risk is an alternative to asset mix diversification
Fund Returns for 60/40% and 40/60% Fund Returns on 60/40% Mix with
Equity/Fixed Income Mix 1Yr Put Spread Collar on 1/2 of Equities
20
20

15 15
Fund Return (%)

10 10

Fund Return (%)

40/60
Allocation Hedged Portfolio 95/80% Put Spread
5 5 with 113.15%
Short Call(a)
0 0
(25) (20) (15) (10) (5) 0 5 10 15 20 25
(25) (20) (15) (10) (5) 0 5 10 15 20 25 30
(5)
(5)
(10) 60/40 Allocation (10) 60/40 Allocation
(15)
Equity Return (15) Equity Return

n Altering the fixed income weighting reduces up and downside

proportionally
n Hedging strategies can be structured to trade off underperforman ce
in a target return range for outperformance in declining markets
Source: Goldman Sachs
12
Response 1: Hedge Equity Portfolio with
Options
Index options activity has been on a steep upward trend reflecting
increased investor hedging
300
Volume (Contracts)

200

100

0
S&P 500 EuroSTOXX FTSE DAX Nikkei 225
50
2001 2002 Q1 2003

Source: Goldman Sachs

13
Response 1: Hedge Equity Portfolio with
Options
which has reflected itself in higher prices for downside protection

40%
FTSE DAX

35%

30%

25%

20%

15%
Jan-02

Feb-02

Mar-02

Apr-02

May-02

Jun-02

Jul-02

Aug-02

Sep-02

Oct-02

Nov-02

Dec-02

Jan-03

Feb-03

Mar-03
Note: 3 Month implied volatility skew divided by at-the-money volatility
Source: Goldman Sachs
14
 Response 2: Reduce active exposures

Hugging Benchmarks Has Been Rational

Holding the worst performing stocks has been especially painful
80 Rational responses include:
Performance Relative to S&P 500

Best 50 Stock Portfolio Minimize concentrated bets

40 Diversify
Sell calls against large
overweights
0
Sell puts against cash to buy
at target levels
-40 The pain from holding
Worst 50 Stock Portfolio the worst names has
been greater than the
-80 benefit from holding the
12/92
12/93
12/94
12/95
12/96
12/97
12/90
12/91

12/98
12/99
12/00
12/01

best names

15
 Response 3: Investors Use More Index
Futures
Activity in futures has increased at the expense of stock
volumes
4

2000 2001 2002 2003Q1

Futures to Stock Ratio

0
US Europe FTSE CAC40 DAX Pacific

Source: Goldman Sachs

16
 Response 3: And other index products

Other index like products have benefited

Portfolio trading as % of NYSE Volume ETF volume as % of NYSE volume

25%

20%

20%

15% 15%

10%

10%

5%

5% 0%
April' 03
99q2

00q2

00q4

01q2

01q4

02q2

02q4
99q4

Jan-97

Jan-98

Jan-00

Jan-01

Jan-02

Jan-03
Jan-99
Source: Goldman Sachs

17
 Response 4: Look for alternative sources of
alpha
Sell call options against individual names as an additional
source of alpha
Motivations Results
Low expected 40 -1.8%

Annualized Return (%)

-3.7% -2.1%
-1.6%
returns -0.6%
20
High volatility
0
Reduce portfolio
S&P 100 Return +1.4% +1.4%
risk -20
Overwriting Strategy Return

Increase income -40 +1.8%

1995 1996 1997 1998 1999 2000 2001 2002
Note: Overwrite 25% of each stock position
Source: Goldman Sachs

18
The increasing importance of derivatives

Investor responses imply more derivatives usage.

This has increased the importance of derivatives in markets:

n Price discovery and leadership in derivative markets

n Risks transferred from one asset class to another

19
 Price Discovery in Derivatives Markets

Example: Hedging demand by institutional investors determined th e

level of the FTSE
Delta Profile by Expiry Delta Profile by Market Move
Market move
Dec-02 Mar-03 Jun-03 Sep-03 Dec-03 Mar-04 -10% -5% 0% 5% 10%
2,000 0

21-Mar-03
2,500
-5

Net open interest delta EUR BN

3,000 17-Apr-03
-10
20-Jun-03
3,500 Index
Level
-15 19-Sep-03
4,000 19-Dec-03

-20
4,500

Positive net delta Negative net delta -25

5,000

-30

Source: Goldman Sachs

20
 Price Leadership in Derivatives Markets

Example: Increasing call option demand at turning point in

market
Call/Put Ratio for FTSE 100 Index Options

6 4200

5 4000

FTSE 100 Index Level

Call/Put Ratio

4 3800

3 3600

2 3400

1 3200

0 3000
Jan-03 Feb-03 Mar-03 Apr-03 May-03 Jun-03

Source: Goldman Sachs 21

 Risk Transfer Between Equity Prices and
Credit Spreads
The relationship between equity prices and credit spreads have
changed massively over the last few years
This has coincided with a differing attitude to risk displayed b y investors

The relationship between credit spreads and equity markets

1400
Jan99-Mar2000 Apr2000-Oct2002 Nov2002-May2003
US HY Credit Spread

1000

600

200
0 1000 2000 3000 4000 5000
NDX Level

Source: Goldman Sachs 22

 The convergence of equity volatility and
credit
The risk transfer resulted in implied equity volatility and credit
spreads moving together

60
CDS 150: Average of 1mth 200
implied volatility

50

CDS 150 Levels

Volatility (%)

150

40

CDS 150 Levels 100

30

20 50
Sep-02

Dec-02
Mar-02

Mar-03
Jun-02

Source: Goldman Sachs

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III. What does it mean for your
investment process?

24
Implications

The world has changed so that funds are more likely to

outperform if they can have

n Flexibility and speed

n Use of variety of instruments
n Ability to search for alpha across boundaries

These are the main differences between traditional active funds

and hedge funds

25
 Traditional vs Dynamic Strategies

Traditional risk measures based on symmetric risk may fail to capture

the correct risks in a dynamic environment
Risk/Return Trade-
Trade-off Downside/Upside Trade-
Trade-off
8% 22.5%
Unhedged Unhedged

Put Spread Put Spread

Put
Expected Return

Upside Potential
20.0%
Futures Put
6%
Put Spread Collar

Collar 17.5%

Put Spread Collar

Futures

Collar
4% 15.0%
15% 20% 25% 10% 12% 14% 16%
Std dev of return Expected Shortfall
Source: Goldman Sachs
Note: Based on hedging an S&P 500 portfolio for one year. All hedging strategies have a VaR or 18% calculated on 90% level of
confidence and have lowest possible cost. 26
Investment Styles: The choice between alpha
and beta and use of derivatives

Style Tools
Beta
Futures
Emerging
Markets

Global ETFs
Macro
Growth
Passive Fund of Funds
Value
Equity Finance
Opportunistic

Event Index Options

Driven

Market
Neutral Single Stock Options
Alpha
Derivatives Usage
Extensive Low Extensive Source: Goldman Sachs
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Responses and Implications to Recent Trends

Recent trends in global markets

n High volatility, low diversification, equity bond dislocation

How have investors responded?

n More usage of equity derivatives

What does it mean for your investment process?

n You need to be fast and flexible and you really can use
derivatives in your process

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