The cheap, long-term hedges are attracting institutional investors and traders as well as a retail clientele.

By Robert Hunter

In the early days of index LEAPS contracts, the acronym was darkly descriptive of the product—those who owned it may have felt the urge to LEAP off the roofs of their office buildings. Dreadfully low liquidity and general uneasiness by traders translated into dismal action early on.

But these days, index LEAPS are starting to heat up, thanks in part to the runaway stock market of 1997 and an influx of retail investors into the options market.

Index LEAPS spun off of equity LEAPS, or long-dated equity anticipation securities, which were introduced in 1990. Whereas LEAPS allow users to take relatively long positions on underlying equities, index LEAPS allow users to make long-term bets on market indices. The Chicago Board Options Exchange and the American Stock Exchange are the most active exchanges in the index LEAPS market, offering products with varying expirations (as long as six years) for indices as broad as the S&P 500 and for such narrowly exposed positions as biotech and telecommunications funds and the AMEX Oil Index.

Logical LEAPS

Sitting back with a cool drink and an index LEAPS contract is becoming increasingly popular among investors of all types. According to Terry Haggerty, senior instructor at the CBOE's Options Institute, index LEAPS in general are "pretty much at record volume right now.” The S&P 500 LEAPS contract, the most popular index LEAPS product, has enjoyed unprecedented success through 1997. Average daily volume through May of this year was twice that of 1996, which was nearly twice that of 1995 (see chart, next page), and open interest on the contract was up more than 90 percent over last year.

"The number of people who are good at making one-minute, one-hour, one-day-type trading decisions is small. But when you expand that out to 12 and 24 months, the people who can be correct on the direction of the market over that kind of time frame gets significantly larger.” Mike Bickford senior vice president of derivatives marketing and research, AMEX

Much of the increased volume is coming from retail investors. Most index LEAPS are reduced-value contracts, set at one-tenth of the value of the index. This helps keep premiums low and encourages retail investors. "Individuals now have slightly more than 50 percent participation in our volume,” says the CBOE's Haggerty. "Most of the index LEAPS that are traded are reduced-value contracts, and by definition they are retail-type contracts.”

But index LEAPS are attracting plenty of interest from institutional investors and traders as well. According to Harrison Roth, first vice president and senior strategist at Cowen and Co. and author of LEAPS: What they are and how to use them for profit and protection (Irwin, 1994), index LEAPS users are "mostly professionals, and some members of the public.” Salespeople who work strictly with institutional clients, such as Leon Gross, vice president of equity derivatives and product manager at Salomon Brothers, have seen increased interest in index LEAPS of late, although trading volumes are nowhere near that of short-term index options. "People aren't using them to time the market or go in and out,” he says. "They're long-term strategies. It's a portfolio decision.”

Index LEAPS have proved to be an ideal mechanism for institutional investors who believe that a large correction is inevitable after the irrational exuberance of Wall Street recently. But maybe the correction is not right around the corner—maybe it's nine months, a year or more in the offing. Rather than buying, say, 12 one-month puts to take a year-long position on the market, investors can buy a single one-year put and avoid 11 contract premiums throughout the course of the year. "It's a cheap hedge,” says Salomon's Gross. "Option premiums do not assume a linear function of how much time there is until expiration, so a one-year option doesn't cost 12 times as much as a one-month option—in fact it costs much less.”

But who wants to get stuck with a one-, two- or even three-year index option? Plenty of people, says Mike Bickford, senior vice president of derivatives marketing and research at the AMEX. "The number of people who are good at making one-minute, one-hour, one-day-type trading decisions is small. But when you expand that out to 12 and 24 months, the people who can be correct on the direction of the market over that kind of time frame gets significantly larger.”

Cheap hedge

Index LEAPS are most often used as cheap hedges for complex, long-term equity positions. Retail and institutional investors who buy products such as SPDRs (the American Stock Exchange's S&P Depository Receipt product that provides long-term, broad-based equity exposure) often look to similarly broad-based index options to hedge their risk. In many cases, they use the dividends from the SPDR to buy a reduced-value index LEAP put, and are left with a little or no-risk position and all of the upside.

Index LEAPS also allow investors to fine-tune hedges to particular indices. Tech-heavy funds, for instance, can be hedged using the CBOE's Russell 2,000 Index LEAP, and foreign-dominated funds can be hedged using products that range from the CBOE's Mexico and Nikkei 300 index LEAPS to the AMEX's Hong Kong 30 and AMEX Oil Index LEAP.

SPX Leaps (S&P 500) Contract Volume and Open Interest

	Contract Volume			Average Daily	Open
	Total	Call	Put	Volume	Interest
Jan–May 1997	491,112	N/A	N/A	4,722	522,540
1996	514,950	14,885	500,065	2,027	254,366
1995	282,413	7,919	274,494	1,121	162,405
1994	310,733	10,759	299,974	1,233	108,003
1993	46,451	1,413	145,038	579	67,784
1992	130,410	2,280	128,130	513	133,264
1991	156,421	5,028	111,393	652	111,404
Source: The Chicago Board Options Exchange

Institutional investors are particularly drawn to their long shelf-life. A one-year index LEAPS put retains most of its value even after three or four months of index appreciation, whereas one-month puts would have expired worthless during the same period. The delta for an index LEAPS, which measures the rate of change of the option's value for every change in the value of the index, is fairly constant, meaning that small daily changes in index value have little effect on the relative value of index LEAPS contracts. As a result, the gamma, which measures the rate of change of the delta for each unit of change in the index's value, is quite low. Fifty-point fluctuations in either direction thus have little long-term affect on the value of the option. "One month of time will have very little effect on the value of the option,” says Gross.

Lately, a number of investors have used LEAPS successfully to make leveraged stock market bets. Like all options, index LEAPS have no margin requirement, so investors can take long-term positions without financing. An investor could have bought S&P 500 LEAP calls on January 21 at 211/2. By June bids on the contract had risen to 1631/2. "Buying a long-dated call on the S&P is essentially a financing trade,” says Salomon's Gross. "You're borrowing money to buy the index and, since the market's gone up much higher than the interest rate has, that's been a winning trade for some time.” And index LEAPS calls have been underpriced of late: "The market has been going up much quicker than the rates implied by the option price,” he says.

Index LEAPS serve another important institutional function: "LEAPS are the industry standard for pricing long-dated volatility,” says Salomon's Gross. "If we get an inquiry for an OTC structured transaction with an institutional account, we price the volatility of those options based on the prices we see on the floor. In addition, we will hedge it using LEAPS as well.”

Liquidity, liquidity, liquidity

So what's the downside to index LEAPS? In a word, liquidity. Index LEAPS trade at a fraction of the volume of short-term index options. The CBOE's S&P 500 contract had a total volume of 514,950 in 1996, compared with 24.8 million for short-term S&P 500 options. Moreover, many index LEAPS contracts, including the S&P 500 LEAPS, are European-style, meaning they cannot be exercised until maturity—a factor that hampers liquidity. The relative illiquidity can be traced to their expiration: Index LEAPS expire in December and must be marked-to-market, whereas equity LEAPS expire in January and offer tremendous tax advantages.

The AMEX's Bickford, however, thinks it's unfair to judge the liquidity of index LEAPS based on volume. "Dealers and investors may be building open interest and the floors or specialists or market-makers may be supplying contracts, but that doesn't necessarily mean they're going to trade actively,” he says. "Most of these contracts will trade actively at the bids and offers that are there, even if they haven't traded on that particular day.”

The illiquidity doesn't seem to present much of a problem to institutional traders, who have discovered that long-dated index options often offer bid/ask spreads four or more times wider than short-term options. Their strategy: buying index LEAPS on the bid and selling on the offer, collecting a fat premium along the way. These traders aren't miffed in the least about the relative illiquidity of the index LEAPS market because their strategies usually mirror their short-term trading patterns. After selling an index LEAPS call, they typically hedge their bets buying futures. And when they sell an index LEAPS put, they often sell futures. "They're no different than trading the short-dated stuff,” says one trader.

Traders who play this game have to be careful, however, because the bid/ask spread in volatility terms is much tighter, often hovering around half a volatility point or less. The longer-dated the options contract is, the higher the volatility will be, because the holder is exposed to the vicissitudes of the market for a longer period, and uncertainty is an expensive condition. The relative lure of the monetary bid/ask spread must be balanced with the volatility, and traders generally add up their collective exposure in all of their different options, hedging as a book as opposed to tit for tat. "It all goes into their book,” says Salomon's Gross. "They aggregate the short-term risk with the long-term.”

By Robert Hunter

All traders worth their salt have built up a series of intuitive hunches based on key market patterns they've experienced. On days when inflation numbers come in under expectations, for example, they may feel it's more than likely that volatility will move one way or another in the bond market.

Researching the historical validity of these relationships has been a tedious chore. Now, New York-based Performance Trading Technologies has released The Profile Analyzer, a market database research tool that allows traders to check these types of hunches in seconds.

The program is based on the Chicago Board of Trade's "Market Profile,” an analytical tool that divides the trading day into half-hour increments to assess intraday market levels. Dividing the day in this way allows users to track the immediate effects of market events—from frenzied currency sell-offs to the release of economic statistics and other news events—and view these effects in bar-graph format. The software also provides users with probabilities of events based on various historical scenarios. It includes a number of databases that are updated nightly on the firm's web site, providing up-to-date market information for historical data searches from January 2, 1991, to the present. The databases are based on five different types of information—market data, notes, news, day types and spreadsheets—and are cross-linked and fully searchable.

Users trying to find out, for example, how often the S&P 500 has closed higher on the day of a Federal Reserve Open Market Committee meeting would select the S&P 500 database from a list of more than 40 databases, call up the dialogue box in which questions are framed and choose "FOMC Meeting” from a menu in the economic statistics section. They'd learn that since January 2, 1991, there have been 63 days when there has been a FMOC meeting.

Users could then refine the search to identify the days among those 63 in which the S&P 500 has closed higher than the previous day by framing another search based on closing price. The Profile Analyzer calculates that in 35 of the 63 days—55.6 percent—this scenario has taken place. Refining the search to determine, for instance, where the S&P closed a week or month later is just as simple, and searches can be refined as often as the user wishes.

The applications of this data-mining capability to derivatives are virtually limitless. Historical data on the S&P 500 and currency markets can be used to determine how often, say, the S&P 500 has increased by more than 1 percent on days when the Consumer Price Index has been announced and inflation came in lower than expected, or when the Deutsche mark has depreciated by more than 1 percent against the dollar when employment reports showing robust job growth are released. Users can customize their questions based on their particular trading styles, and can compose their own questions using TPA BASIC when pull-down menus don't provide the adequate framework. Users can also incorporate their own notes, observations and data for added flexibility.

"I use it purely to determine how volatile each day has been in relation to other days,” says one Connecticut-based options trader. "If employment numbers are released, say, on Friday, June 6, I look at all the employment numbers for the past six years and how they affected volatility. You're able to sort the results, so if employment numbers exceed expectations—the economy is growing faster than normal—you can see exactly where the market is two weeks later.”

"In many ways our product is the easiest way to gauge price volatility among various markets,” says Performance Trading Technologies vice president Kevin Barry. "It allows you to get a look at the underlying instruments in each of these markets and gauge price movement and be able to mimic certain similar market scenarios over time, which will help you make an educated decision about price action going forward.”

The tool can be particularly helpful to derivatives traders who track their own data, because it can import data from various spreadsheets. Users can thus apply the software to their own data, customizing to their particular needs. "The beauty of this software is that you don't have to rely on our data,” says Barry. "Clients can use their own information within the context of the software. That's a unique and potentially powerful part of the program.”

For more information, see www.ptti.com.

LIBOR-financed Treasury repos roll two trades into one.

By J.C. Louis

Investors who find the swap market cumbersome and expensive are the targets for a new product, LIBOR-financed Treasury (LFT) repos, that may help simplify and standardize the plain vanilla swap.

"It's actually a three-month rolling repo,” explains Jim Sherman, managing director of Adams, Viner and Mosler (AVM), a Florida broker-dealer whose involvement in the OTC Treasury repo market positioned it to play a key role in bringing LFT repos to fruition.

LFT repos link the simultaneous purchase (or sale) of a Treasury security with a repurchase (or reverse repurchase) agreement based on the three-month LIBOR. That can help swap market participants hedge interest rate exposure at a significantly lower cost—and with much of the transparency, security, anonymity and liquidity of an exchange-traded instrument.

One price, one transaction

Market participants who hedge their interest-rate risk by buying or selling Treasuries and executing repurchase or reverse repurchase agreements are left with double headaches: two transactions, two time frames and a renegotiated repo rate anytime the duration of the hedge surpasses the expiration of the repo.

By contrast, an LFT repo executes the Treasury and repo at a single, blended price. There is only one transaction in a single time frame, and the repo rate, which is equal to the current quarterly LIBOR rate, is reset quarterly. An LFT repo initially trades with a start date that coincides with the next quarterly International Monetary Market (IMM) value date. LFT repos reset their rates to the newly established three-month LIBOR rate and settle outstanding repo interest for the interest period just ended. On each IMM settlement date, the repo principle value is reset to the then-current net present value (NPV) of the outstanding cash flows. The discount factors for the NPV calculations are derived from the implied zero curve of the swap curve.

The idea behind LFT repos started with Adams, Viner and Mosler, a long-time participant in the OTC repo markets. Warren Mosler, an AVM principal, came up with the idea of using Treasuries in a hedging strategy for users with interest rate risk who were oriented toward holding repos to maturity.

Many benefits

"The similarity of cash flows between a treasury repo and a swap suggested an obvious fit,” says AVM adviser Bill McCauley. "When you own a Treasury and repo it, you receive fixed and pay floating, which is the same as a swap. Treasury repos and Delta Securities already existed, so we asked: ‘Why not standardize the process, clear the trades with Delta and forget going through all the hoops and hurdles in the swap market?'”

Reaction from the dealer community has been mixed, but encouraging. The standardization is obviously quite appealing. "Currently, each swap has its own unique payment dates, its own fixed coupons and LIBOR fixes,” notes one swap dealer. "To unwind it takes time, effort and expense, with quotes from the swap dealer.” According to Rob Printz, managing director of BZW, "An LFT repo has all the characteristics of an interest rate swap, but it is more commodity-like in nature.”

The LFT product has another strength—a focus on price. "The swap market has been quoted on a yield basis,” observes one dealer, "but most fixed-income bond traders think in price terms. The LFT repo product has standardized all trades so that they have fixed coupons and three-month LIBOR rates, which enables them to trade on prices rather than yields.” Sherman asserts that "There is no personality in LFT repo math—it is Vulcan. It is transparent.” Transparency is another advantage. Participants quote live, screen-based, dollar spread markets in 32nds to one another, or through an interdealer broker. Using an assumption about the yield curve and the spread to Treasuries of a particular LFT repo, traders may use their own pricing model or one provided by Bloomberg to determine a price. "With an LFT repo,” observes one enthusiastic dealer, "you can quote the ‘8's of 06' and, boom, all the details are in the model. You can trade efficiently, going in or out.”

Having Delta as an SEC-regulated and AAA-backed counterparty for all LFT repo transactions simplifies cash and margin maintenance and eliminates the need to deal with every counterparty individually. All cash and margin calculations are reduced to one daily net figure for each participant.

"We asked: ‘Why not standardize the process, clear the trades with Delta and forget going through all the hoops and hurdles in the swap market?'” Bill McCauley AVM adviser

Supporters see LFT repos as an OTC product that heralds many of the benefits of a listed issue. "LFT repos are a hedge surrogate for those that do not use swaps,” says Sherman. BZW's Printz agrees that they will "allow broader participation of people that are not necessarily involved in swaps right now.” The appeal is expected to be strong, said one dealer, "among prospects for whom the costs of swaps are a little too high.”

Another dealer sees potential demand among large cash-based institutional investors who increasingly leverage the buying power of their fixed-income portfolios but lack the legal right to do swaps. "Buying an LFT repo would allow one to receive a fixed rate vs. paying LIBOR and enjoy all the benefits of a fixed-floating swap, such as added leverage. Whoever does not have direct access to the swap market may now be able to get it through LFT repos.”

Sherman expects a lot of LFT repo activity among experienced swap and repo users ranging from mortgage-and asset-backed desks to corporate issuers of debt or those using swaps to offset debt, on or off the balance sheet. Because LFT repos can be treated as the purchase and sale of the same security, the instrument avoids a liability recorded on the balance sheet. Off-balance-sheet treatment can also be achieved under the provisions of FASB 41, which allow balance sheet set-off of Treasury repos and reverse repos so long as each has the same end date and are with the same counterparty (Delta, in the case of LFT repos.)

Few drawbacks

Supporters and dealers see few potential drawbacks to LFT repos. "Initial bid-offer spreads could be wider than the OTC market,” says Rich Rosenberg, senior vice president of Exco Financial Products. "However, the significant savings on transaction and processing costs would increase the number of people getting involved in LFT repos.”

At the same time, asserts a trader from a major dealer, "LFT repos lack the tremendous flexibility of swaps in terms of start dates and reference points.” As a result, large-volume dealers with hefty administrative apparatuses might initially be disinclined to disrupt their practices with big established clients, even for plain vanilla swaps. "Big dealers are not going to save any money,” predicts another New York dealer who expects the product to be very attractive to small and medium-sized end-users doing one to two swaps per day.

For more information call Adams, Viner and Mosler at 800-877-1423.