Farid Naib, CEO of FNX Software, takes a backward and forward look at major developments in the derivatives market.

The financial markets are never static and always evolving as different products, contracts, risk management techniques and participants constantly change. Looking back, here are the major developments as I saw them develop:

Late 1980s: During this time, the market concerned itself with the accuracy of its pricing models. As incredible as it may seem, American-style options were considered almost exotic at this time, and there was a wide variance in pricing models. People were trying to validate their models, and there was a somewhat uneasy alliance between the academic community and the markets. While the academic community provided pricing models, these models often ignored actual market considerations—they might assume, for example, that an option's value date and maturity date were the same.

Toward the end of the decade, risk reports and tools came into vogue. These were not yet cross-desk reports, but desk-specific, showing the response of the current portfolio to changes in market conditions.

Spreads were wide in these years in basic products, so efficiency was not nearly as important as it is today. The fat spreads and large profits drew many participants to create trading operations. During this time, we started to see the first shift toward creating subsidiaries with a higher rating then the parents as trading vehicles.

Early 1990s: The early 1990s saw the continued development of pricing models, including the acceptance of exotic options models and structured products. There were several reasons for this innovation. Some exotics were created to allow buy-side groups to hedge their specific risks better. Others were created to lower the cost of these derivatives, presumably to sell more of them. And finally, the most obvious reason was that new products like barrier options or average-rate options could be traded at a wider spread than the now well-understood "simple” derivative.

Mid-1990s: One of the biggest trends in this period was the development and introduction into the wider market of VAR and Risk Metrics by JP Morgan. This allowed firms to get an overall, composite view of their risk in a widely accepted measure for the first time. The biggest problem was that many people did not really understand how to use these tools. For example, an acceptable loss level with a 95 percent confidence level meant that the loss could be higher on one out of twenty days or more. While these models continue to be used, they have become less of the final answer to risk management and more often just another tool.

The second great trend in the mid-1990s was the creation of new markets, particularly in areas such as energy, but including almost anything that might be tradable. Again, one of the reasons for this shift was that new markets have wider spreads and therefore greater profit-and-loss opportunities. I saw a number of traders move from currency options to electricity derivatives.

The mid-1990s also saw the growth of the global book; that is, a book continuously traded 24 hours a day, usually by locating trading operations in London, New York and Singapore.

Late 1990s: The late 1990s saw the growth of concern in operational risk, as firms began to realize that the largest losses came not from market moves and pricing-model errors, but from rogue traders and human issues. To combat this, the concept of straight-through processing came into vogue, setting an automated processing system for all stages of the transaction life.

This was an interesting time for the vendor community. Since STP involved the entire life cycle of the transaction, any firm that handled a part of that life cycle felt qualified to claim it provided STP.

2000 and beyond: We are currently in the midst of the most profound change I have seen to date—the advent of the Internet as a delivery and propagation media. Some of the ramifications of the change include:

The cost of information is in decline, because the buy-side can finally have the same information as the sell-side. However the value of information is probably increasing, as it becomes easier to act on it.

The growth of electronic communication networks means that sell-side groups must cut their prices (spreads) to be competitive. We have recently seen the introduction of a firm making 5 basis-point spreads on small foreign exchange amounts, something that would have been unheard of for all but the best clients' largest trades only five years ago.

As a result of the ease of trading over the Internet, I believe that volumes will grow over the next few years, but that the volumes of more exotic derivatives will decline, because of the difficulty in explaining them. On the positive side, it will be easier to trade a wider assortment of products on-line.

Smaller firms may be able to compete more directly with larger firms, since the Internet lowers the cost of information as well as the cost of infrastructure by using Internet delivery. ASPs will also come to dominate the delivery mechanism of risk management software.

Ivan Stux, senior quantitative strategist at Morgan Stanley Dean Witter, explains how to construct a better equity collar.

When we invest, we all want the most upside we can get and as little downside risk as possible. The stock market in the last few years has fulfilled this desire. In fact, the compounded total return on a Standard & Poor's 500 investment over the last five years was 28.6 percent, much higher than the 13.6 percent long-term (50-year) historical experience. As a result, the market is becoming ever more the investment of choice for increasing numbers of participants.

Yet the current U.S. market also poses a difficult dilemma for investors. From a longer-term (mean-reverting) rational-valuation perspective, the market appears overvalued; therefore, maintaining full equity exposure is risky. However, if the "new paradigm” economy continues and the present period of faster growth is maintained, reducing equity exposure may deprive investors of substantial equity gains such as those of the last few years. This dilemma is not dissimilar to what investors faced in Japan in the years prior to 1989. In that case, with hindsight it's clear that getting out too early made investors miss out on years of great appreciation, while staying the course turned out to be a trap because of the decline that followed.

Stocks ultimately derive their value from the earnings stream they generate. Therefore, the question of whether the market reverts to a level consistent with long-term history or continues its current course rests primarily on what earnings will do. Over the last 50 years, earnings for the S&P 500 have grown at 6.5 percent to 7 percent per year compounded, a rate sustainable over the long term in the U.S. economy. These days, however, the market is priced as though earnings will grow much more quickly for the foreseeable future. Are we still on the same long-term historical trend, or have we entered a new era in which faster growth will be the norm? The first of these alternatives spells trouble for the market; the second, supported by new-paradigm thinking, is far more positive.

There are strong arguments in favor of continued optimism and the new economic paradigm because of the unique opportunities in the U.S. and Europe, and indeed the rest of the world, mostly linked to technology, the information boom and the global move toward freer economies. If these positives persist, the era of prosperity and profitability is likely to continue, and exposure to equities will remain beneficial. Strong counterarguments can also be made, however, since many things can go wrong. Fast growth could finally precipitate wage pressures and inflation, U.S. consumers could get spooked and stop spending, or a slowdown in certain European economies or divergences in social objectives could weaken and disrupt monetary union plans. If even a few of the many possible problems occur, the new paradigm will turn out to be an illusion and exposure to equities will be damaging.

A STRATEGY IS NEEDED THAT PROTECTS AGAINST LOSSES IF THE MARKET DECLINES SHARPLY, YET PARTICIPATES SUFFICIENTLY IN APPRECIATION IF THE "NEW ECONOMY” CONTINUES TO ADVANCE.

To tackle such concerns, traditional strategists typically dig more deeply into their research, seek to discern which outcome is more likely, and then take a corresponding course of action in terms of asset allocation. Yet this time around, the nature of the divergences and uncertainties is such that the outcome is not only difficult to discern but actually unknowable, and the market is facing both a distinct and substantial likelihood of a decline and a distinct and substantial likelihood of continued appreciation. This unknown, therefore, cannot be resolved through research, and the optimal answer is not simply asset reallocation, since taking a bet one way or the other, at a time when the likelihood for the alternative outcome is substantial, can be quite costly if wrong.

The answer instead lies in the use of well-designed options-based hedging strategies. In typical times of heightened risk of a decline, investors have traditionally protected themselves using options in either of two ways: with a protective put or a zero-premium collar. In the case of the protective put, an upfront premium is paid to purchase the option. In the case of a zero-premium collar, the cost of the put is recovered by selling an equally priced call of the same expiration, in effect paying for the put by giving up the opportunity to participate in gains beyond the strike of the call.

Both of these strategies are effective if the market declines during the life of the options (which, often, is for one year). But if the market does not decline and the investor continues to deem protection necessary, the repeated application of either of these two strategies can prove costly. The outright put purchase is costly in terms of the actual out-of-pocket costs incurred, and the zero-premium collar in terms of giving up the gains beyond the strike of the call if the market advances sufficiently.

Another problem with both these strategies is that if during the, say, one-year life to the expiry of the overlay, the market first advances and then declines, the gains from the advance will not be protected. Also, if the market first declines and then recovers, the protection would not pay off for that decline.

Hence, while these strategies are effective during a decline and, therefore, are good tactical defensive moves, they are not the best vehicles for straddling the two horns of the current dilemma, especially for a potentially extended period of time. Instead, a strategy is needed that responds head-on to the potentially protracted dilemma in the current market: a strategy that protects against losses if the market mean-reverts to the old trend and declines sharply, yet participates sufficiently in appreciation if the "new economy” prevails and the market continues to advance. Also, this strategy has to be sustainable in the longer term without incurring large out-of-pocket or opportunity costs. The flexible collar is one such strategy.

At the core of the flexible collar is a judiciously managed, flexible and path-dependent long-put/short-call collar-type overlay. In its basic form (without all the flexibilities that are available), the flexible collar consists of the following:

1. Buy a 12-month 3 percent out-of-the-money S&P 500 put in a notional amount equal to the size of the protected portfolio.
2. Sell a three-month 7 percent to 11 percent out-of-the-money S&P 500 call in the same notional amount.
3. Sell a three-month 14 percent to 18 percent out-of-the-money S&P 500 put in the same notional amount.
4. After three months, as the short options expire, liquidate the long (nine-month) put and re-establish the original position at the new market level and asset size of the portfolio. (The preferable strikes for the various options depend on the volatility of the market.)

In this instance, the long put provides the protection while the short calls (and puts) defray the cost. The quarterly resets make the protection ongoing and move the floor and ceiling of the structure in relation to the market level as the market moves.

THE FLEXIBLE COLLAR TYPICALLY REQUIRES A NET INITIAL INVESTMENT OF 4 PERCENT TO 6 PERCENT OF THE NOTIONAL VALUE OF THE INVESTMENT BEING PROTECTED.

Since the flexible collar strategy is reset periodically, to understand its impact on asset performance one has first to look at its quarterly payoff profile as compared with the performance of the unprotected asset—this is shown in Figure 1. Then, one has also to look at the annual performance of the protected position, since it comes from the compounding of the periodic performance, and compare that with the performance of the unprotected asset.

Figure 1 shows the payoff profile of the flexible collar overlay at the time when the short options are about to expire and the position is about to be reset. The thick solid line is the base case, when both a short-term call and a short-term put were sold to finance the long put. The thin line is an extreme—neither of the short options was sold and the otherwise collectible premium was foregone for that period in exchange for retaining exposure to the tails of the return distribution. More generally, if one chooses to sell only one of the tail's benefits or raise the ceiling (the strike of the short call) or lower the floor (the strike of the short put), the resulting payoff profile will be in between these two extremes.

The flexible collar, like the standard collar, gives up some of the potential benefits that would accrue from a large appreciation in the market, because of the cap imposed by the short call. But here, the short call is of only three months duration and the give-ups happen because of relatively large shorter-term market moves only. If the market is on an uptrend, since the flexible collar is rolled quarterly, it will tend both to capture a much larger upside than the standard collar and also to protect the quarterly accumulated gains. If the market declines, the long put in the flexible collar will add value, but will also give up some of its time value—in effect, paying for the protection like a put-only protection, but only during market declines.

These features—that the flexible collar behaves more put-like on the downside and more as a short-term collar on the upside, and that the structure is rolled quarterly—combine to make it a better alternative than either of the other two and especially well-suited for the current market uncertainty.

As distinct from a standard zero-premium collar, the flexible collar typically requires a net initial investment of between two-thirds and three-quarters of the initial value of the long put, representing 4 percent to 6 percent of the notional value of the investment being protected. As distinct from an outright put purchase, however, this investment is lower and, importantly, it is recovered over time through the repeated sale of the short options during the life of the long put (on average, the four such quarterly options sales available will defray the premium of the put). In fact, if the market stays flat or advances by up to the strike of the call, and option pricing is stable, the liquidation value of the long put at three months (with nine months left to expiration) is typically higher than the net initial investment in the overlay. In this way the initial investment is fully recovered and, as with a zero-premium collar, the strategy self-finances in this range of quarterly advances. If the market advances beyond the strike of the short call, the net value of the flexible collar strategy will start to decline, as is the case with standard collars, and this offsets the advance of the underlying portfolio.

The strategy protects the principal as well as the quarterly accumulated gains, and this protection is paid for mostly by forgoing quarterly gains that go beyond the cap that is imposed flexibly by the investor. Thus, during even fairly significant market gains, if they are relatively orderly, the strategy is mostly self-financing. This allows the strategy to be kept in place over the long haul without incurring an excessive penalty in performance, a desirable feature especially in the current environment.

Because the flexible collar strategy is a quarterly reset strategy, it is path-dependent. Therefore, the actual return for the strategy over, say, a one-year period, does not simply depend on the return on the market but is also influenced by the quarterly path the market took to get there. And, for each possible outcome in the market, there is a probable distribution of the strategy, conditional on the market return. Deciding if and how this strategy is to be used requires understanding this aspect of the strategy in detail. When, at each expiration, the reset is set exactly in the same relative position with the underlying asset level, without regard to changing market conditions, the strategy is in its simplest, most basic form. As such, it is a disciplined strategy, with precisely defined trading rules applied quarterly. Figure 2a shows a pro forma performance of the strategy under these restrictions (and where a current fixed level of option pricing is used), for the period 1988–2000.

These rules can also be fine-tuned and applied more effectively given additional information, which means the strategy's effectiveness can be further improved beyond the base-case implementation. This is accomplished by modulating the level of the strikes of the options employed and by trading the position and resetting it early under certain market conditions. Specific rules involving market performance and valuation and the pricing of options can be set out to insure that these improvements in the performance of the strategies are also achieved in a disciplined and precise way.

For example, in any given quarter when the market may be poised for a major advance—for example, after a sharp decline—one can increase the strike of the short call or even not write one at all. Alternatively, the sale of the short-term put can be forgone if a substantially large decline in the next two months to three months is feared. Finally, if the market declines by a sufficient amount, the position can be reset early to benefit from reinvesting the proceeds on the put in case of a recovery. Additional value here derives from the fact that these decisions (or flexibilities) are easier to carry out and involve much lower unit costs (for example, the premium differential between different strike three-month calls). Moreover, these decisions are for a much shorter duration than what is feasible with standard collar or protective put strategies.

It is important to note that the flexibilities described are not hidden ways of market-timing the protection itself. In fact, the flexible collar strategy stipulates the protection to remain in place on an ongoing basis. Rather, these flexibilities refer to the method of payment for the protection. As market outlook and conditions change, the investor can choose for each period (quarter) how to allocate among three methods of payment for the protection: a cap on the opportunity to participate in market gains, a limit on the range of protection, and direct payment, implicit in forgoing some or all of the collectible premiums from the short options.

An important extension of the strategy is to apply it to individual stocks. To do so, certain changes of the underlying structure are required. In particular, because stocks are more highly volatile than indexes, the long put can be of nine months or even shorter duration and the short options should be two months or even less. Also, the long put should be struck further out-of-the-money and, in the case of a decline, early reset is more important, in order to capture the typical implied volatility expansion when stocks decline. In conjunction with this, it may also be advisable not to sell the deep-out-of-the-money put. The judicious application of the flexible collar strategy to individual stocks can turn high-volatility stocks into much lower-risk investments that still have the potential for significant appreciation.

What are the best ways to use the flexible collar strategy? It should be clear that this strategy can beat equity performance only when equities decline or do not advance substantially, and that the strategy, therefore, is a defensive approach to investing. The flexible collar strategy is not designed as an approach to equity outperformance in the total-return sense and under all conditions, and if the goal is to beat an equity benchmark in this absolute sense, this strategy is not appropriate. Also, while usable in this way, the flexible collar strategy is not designed as a tactical tool to apply as protection only at times when a decline is viewed as imminent. In these cases, as was pointed out earlier, a straight put or a standard collar can be used. The flexible collar is designed, instead, to yield superior performance on an ongoing basis in a risk-adjusted sense. As a result, its best use is as part of an overall asset allocation strategy.

For example, in the current market, with its heightened level of uncertainty for investors, the flexible collar strategy is a response to the dilemma of whether or not to reduce equity exposure. The strategy establishes a counterweight overlay that provides protection without giving up too much on the upside. Another example is in the context of the equity/bond strategic mix. If an investor is trying to reduce equity exposure, an alternative worth pursuing would instead be to put a flexible collar overlay on the equity portion that would otherwise be sold. By doing this, a lot of the upside of the equity market for these assets is retained, while a substantial part of their equity risk is eliminated.

Yet another example is to replace a two-way allocation between equity and bonds with a three-way allocation between equity, equity with a flexible collar and bonds. For instance, if the allocation was 70 percent equity and 30 percent bonds, a slice of both equity position and bond positions, let's say 15 percent equity and 7 percent bonds, could be replaced by a flexible collar protected equity. The new, three-way combination (55 percent–22 percent–23 percent) should have a superior return/risk profile, sit on a more highly efficient frontier, and is likely to outperform the two-way combination (see Figures 2a and 2b for a comparison with the 70–30 stock/bond allocation).