Jim Dull, CFA

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Concentrated Position Risk Management
Tuesday, April 18, 2006
University of Colorado at Boulder Finance 4040
Derivatives
Jim Dull, CFA Financial Advisor
Jeremy Shevlin, CFP Financial Advisor
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Table of Contents

• Introduction to Crestone Capital Advisors LLC
• Concentrated Position Risk Management
• Zero-Premium Collar Example
• Variable Pre-Paid Forward Example
• OTC vs. Exchange-Traded Options
• Hedging Constraints
• Derivatives Exchanges
• Question Answer Session

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I. Introduction to Crestone Capital Advisors LLC

• Crestone Capital Advisors LLC (Crestone), based
  in Boulder, Colorado, is an independent wealth
  management firm for high net worth individuals,
  families, and foundations.
• Our services include investment management,
  concentrated position risk management, estate and
  philanthropic planning, and income tax planning
  and reporting.

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II. Concentrated Position Risk Management
Reasons to Hedge

• Preserve / protect wealth
• Provide liquidity for diversification
• Limit equity risk exposure
• Defer capital gains taxes

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II. Concentrated Position Risk Management (contd)
Benefits
Considerations
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III. Zero-Premium Collar Example

• Zero-Premium Collar Description
• Most common exchange-traded hedging/ monetization
  transaction
• Standardized contracts
• American-style options
• Tax deferral strategy
• Creates downside floor and allows for upside
  participation
• Possible up-front liquidity via margin loan

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III. Zero-Premium Collar Example (contd)
ABC, Inc. 5 Year Price Chart
A
B
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III. Zero-Premium Collar Example (contd)
In early 2002, an investor that owns 100,000
shares of ABC stock executes 1,000 Jan 2003 20
put, 30 call collars for even money (covering
all 100,000 ABC shares) when ABC stock is trading
for 25/share.
A
Short Call
Long Put
Upside Capped Investor does not participate in
upside stock price appreciation above 30.
Upside Participation Investor retains 100 of
upside stock price appreciation less premium paid.
At maturity, if the final price of ABC stock is
30 or lower, the call expires without value.
Call Strike 30
Investor retains first 5 of stock price
appreciation.
Initial Price 25
Investor exposed to first 5 of stock price
depreciation.
of ABC stock
Downside Exposed Investor has no downside
protection other than premium received.
Put Strike 20
At maturity, if the final price of ABC stock is
20 or higher, the put expires without value.
Downside Protected Investor has downside
protection at 20 and below.
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III. Zero-Premium Collar Example (contd)
Zero-Premium Collar
Upside Capped Investor does not participate in
upside stock price appreciation above 30.
Call Strike 30
Investor retains first 5 of stock price
appreciation
At maturity, if the final price of ABC stock is
at or between 20 and 30, both the call and put
options expire without value.
Initial Price 25
of ABC stock
And is exposed to first 5 of stock price
depreciation.
And is exposed to first (y-x) of depreciation.
Put Strike 20
Downside Protected Investor has downside
protection at 20 and below.
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III. Zero-Premium Collar Example (contd)
ABC, Inc. 5 Year Price Chart
A
B
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III. Zero-Premium Collar Example (contd)
In September 2002, the same investor exits 1,000
Jan 2003 20 put, 30 call collars for 10 per
contract (covering 100,000 ABC shares) when ABC
stock is trading for 10/share and retains his
100,000 long ABC shares.
B
Put Sale Intrinsic value 10.00 Time Value
0.00
Total Gain on Hedge
1,000 contracts x 9.95/contract x 100 multiplier

Call Buy Intrinsic value 0.00 Time Value
0.05
995,000
Note that the investor retained his long stock
position but incurred an unrealized loss of
1,500,000
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IV. Variable Pre-Paid Forward Example

• Variable Pre-Paid Forward Description
• Most common OTC hedging/monetization transaction
• Fully customizable contracts
• Most likely European-style options
• Tax deferral strategy
• Creates downside floor and allows for upside
  participation
• Significant up-front liquidity inherent in
  structure

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IV. Variable Pre-Paid Forward Example (contd)
In early 2002, an investor that owns 100,000
shares of ABC stock enters into a 3 year VPF
contract when ABC stock is trading for 25/share.
The VPF is structured with a minimum
price/share value of 100 (25/share), maximum
price/share value of 120 (30/share), and a cash
advance of 84 (21/share).
Maturity
Trade Date
Three Years
Upper Strike 30
Investor retains up to 5 of appreciation
Lower Strike 25
Investor is fully protected below 25, less
implied financing costs
Advance 21
(Investor receives 2.1M upfront)
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IV. Variable Pre-Paid Forward Example (contd)
ABC, Inc. 5 Year Price Chart
A
B
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IV. Variable Pre-Paid Forward Example (contd)

• In early 2005, the price of ABC is 12 and the
  investor settles the trade
• by delivering 100,000 shares of ABC stock to the
  counterparty.
• Had the investor remained un-hedged over the 3
  year period and held
• the long position, she would have lost the
  benefit of investing the
• 2.1M cash advance and would now only have 1.2M
  worth of ABC
• stock.

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V. OTC vs. Exchange-Traded Options

• OTC
• Customized
• Counterparty risk
• More expensive
• Largely unregulated
• Privately negotiated
• Less liquid

• Exchange-Traded
• Standardized
• No counterparty risk
• Less expensive
• Regulated
• Publicly traded
• More liquid

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VI. Hedging Constraints

• Regulatory
• Rule 144
• Section 16(b)
• Margin requirements
• Trading windows

• Practical/Operational
• Liquidity
• Marginability of shares
• Float (borrow)
• Behavioral constraints

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VII. Derivatives Exchanges

• Futures Exchanges
• Chicago Mercantile Exchange (CME)
• Chicago Board of Trade (CBOT)
• New York Mercantile Exchange (NYMEX)
• Equity Option Exchanges
• Chicago Board Options Exchange (CBOE)
• American Stock and Options Exchange (AMEX)
• Philadelphia Stock Exchange (PHLX)
• Boston Options Exchange (BOX)
• International Securities Exchange (ISE)

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VIII. Question Answer Session