Options

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UNDERSTANDING ASSET CLASSES

An educational series by Clearwater Analytics explaining the many complex asset classes available to institutional investors today.

Options Options are often thought of as risky, complex investments. The use of credit default swaps (a binary option) by Lehman Brothers, AIG, and Bear Sterns are famous examples of options mismanagement, and the news' headlines associated with those companies’ collapses did little to quell concerns surrounding these securities. Yet options are a part of everyday life. Individual health insurance, for example, is an option purchased by a person who assumes that the cost of his or her health care will rise. The upfront insurance premium, which can be likened to the cost of purchasing a call option, ensures that the person buying the insurance will pay only a known amount or rate for health services, regardless of fluctuations in the market cost of health services. The insurance company—or the option seller in this case—assumes the potentially unlimited risk that the insurance buyer could be unhealthy and have large medical bills. But insurance companies expect that if they sell policies to a large number of people, most of them will not have high medical expenses, and on average this option will earn a profit.

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With the Great Recession in the rear-view mirror, many organizations are using—or considering the use of—options. According to the 2014 Insurance Investment Benchmark Survey, approximately one in ten insurers (12 percent) are currently invested in options, while another eight percent are considering them for their portfolios.1

Call Option – gives the holder the right to buy the underlying asset at a pre-determined price. Put Option – gives the holder the right to sell the underlying asset at a pre-determined price.

However, valid concerns about options investing remain. Options can be structured in a dizzying number of ways, often featuring complicated terms and conditions, and the accounting treatment can be difficult, especially when the underlying assets are obscure and data sources are limited.

Strike Price – also known as the exercise price; this is the contractual price at which an option either represents a gain or a loss, depending on the current market price of the underlying asset.

As risky as these investments can be when mismanaged, combining the right options strategy with Clearwater Analytics’ advanced investment accounting and reporting solution—which simplifies the processing and accounting of complex assets—can greatly assist investors in the mitigation of risk, and in the generation of yield.

Exercise – when the buyer of the option chooses to exercise the right to buy or sell the underlying asset and completes a trade in the underlying asset with the seller of the option.

Why Invest in Options? Options are derivative securities, which means that their value is based on the performance of an underlying asset or basket of assets. An option is a contract that gives the buyer the right (or “option”) to buy or sell the option’s underlying asset before a specific date, or at a specific price. These underlying assets are usually financial instruments, such as a stock or commodity. Examples of other common derivative securities include futures (contracts to buy or sell an asset at a specific price on or before a predetermined date) and swaps (contracts to exchange cashflows).

Expiration – the last date on which an option can be exercised. Underlying Security – Also called the Reference Security; the investment security for which the option contract is written. This might also be an index rather than a security.

Buying options provides investors with the peace of mind of a known, limited risk and an understanding of what they potentially stand to lose. The right, rather than the obligation, to exercise the option means that if the purchased option expires worthless, holders will be out no more than the premium invested. This is in contrast to the traditional investment environment, which provides virtually no guarantee of either return or loss, instead exposing investors to unlimited fluctuations in their investments as markets change.

In-the-money or Out-of-the-money – A measure of the difference between the strike price and the market price of the underlying security. If an option is in-themoney at expiration it will be exercised by the buyer. An outof-the-money option will expire worthless.

Insurance companies have traditionally maintained large fixed-income positions. Coupled with the high demand for, and relatively low number of, investment-grade issuers in the fixedincome market, these large fixed-income positions expose investors to issuer (default) risk and interest rate changes, which has in turn led to significant growth in the credit option market by investors looking to hedge against these risks. Similarly, investors looking to protect against large swings in the equity market have both equity and index options at their disposal. In this landscape, options can be a stable choice to hedge against swings in the market, and increase potential investment yields.

Premium – the amount paid for a call or put option.

1. 2014 Insurance Investment Benchmark Survey, sponsored by Clearwater Analytics. http://clearwater-analytics.com/resources/insurance-benchmark-survey

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Basic Structure of Options There are many ways to configure option contracts. At the most basic level, option buyers pay a premium for the right to buy an asset from, or sell an asset to, sellers at a later date for a pre-determined price. Holders (the investor who buys the option—may also be known as the purchaser, buyer, or buy-side party) are not obligated to exercise the option, while writers (the party responsible for fulfilling the options contract) are required to make good on their end of the option. If the holder chooses to let the option expire, the writer keeps the premium. An option that gives the holder the right to buy the underlying asset at a specific price is a call; an option that gives the holder the right to sell the underlying asset at a specific price is a put. There are two primary types of call positions for writers of options contracts, and writers utilize either one depending on risk (see Figure 1). The strike price (also known as the exercise price) is the contractual breakpoint at which an option either represents a gain or a loss, depending on the current market price of the underlying asset. For example, the holder of a call option with a strike price of $50 will not exercise the option when the current market price of the underlying

asset is at $45, since she could purchase the option on the open market for $5 less than the call option is worth ($50 - $45 = option is out of the money $5). In contrast, if the current market price of the underlying asset of the same option is $55, then the holder could exercise the option and net $5 ($55 - $50 = option is in the money $5).

Long Position vs. Short Position When the holder purchases a call option with the expectation that the underlying asset will become more valuable over time, the holder is taking a long position. When an option writer sells the option assuming the underlying asset will become less valuable, the writer is taking a short position. Options may have non-standard terms and conditions that increase holder risk, but in general the primary risk associated with the long position is that the option will expire worthless and the holder will lose the money paid for the option. While there is not a significant amount of capital outlay for option writers at the outset of the option’s contract (some collateral may need to be posted, but the basic

Figure 1: Common Scenarios for Options Counterparties

Put*

Call**

Writer (Seller)

Holder (Buyer)

Sells a put thinking the underlying asset price will rise above the strike price.

Buys a put thinking the underlying asset price will drop below the strike price.

1. If the asset price increases above the strike price, the option will go unexercised

1. If the asset price increases above the strike price, the option will go unexercised

2. If the asset price drops below the strike price, the option will be exercised and the owner of the option will force the writer to purchase the asset at a price higher than current market price

2. If the asset price drops below the strike price, the owner will exercise the option and force the writer to purchase the asset at a price above current market price

Sells a call thinking the underlying asset price will drop below the strike price.

Buys a call thinking the underlying asset price will rise above the strike price.

1. If the asset price does drop below the strike price, the option will go unexercised

1. If the asset price does drop below the strike price, the option will go unexercised

2. If the asset price rises above the strike price, the option will be exercised and the owner will force the writer to sell them the asset at a price that is lower than current market price

2. If the asset price rises above the strike price, the owner will exercise the option and force the writer to sell them the asset at a price below current market price

*A put is more valuable to the holder when the underlying asset price falls during the holding period and when volatility in price increases. **A call is more valuable to the holder when the underlying asset price rises during the holding period and when volatility in price increases.

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transaction involves a cash inflow of the purchase price or premium), the loss potential for option writers is much greater than for the option buyers. An option holder’s risk in the long position is limited to the purchase price of the option, since she can never lose more than the initial amount paid. If the option doesn’t increase in value, the holder doesn’t lose additional money: she simply won’t recoup her initial investment. An option writer assumes more risk in her short position, since her loss is open-ended, depending on the value of the underlying asset after the option has been sold. A writer will lose money on an option position if the market price moves against her position. If the writer is short a call option, an increase in market price may cause losses; a short put option loses when the market declines. At expiration, the writer loses money if the market price has moved through the strike price by more than the amount of the premium received when the trade was initiated.

Underlying Security While options contracts can be sold on a host of underlying securities, for the purposes of this paper we will only discuss two of the most widespread underlying securities in the insurance industry: equities and indexes.

holding the same equity, who believes the value of the security may increase slightly, but may also stay near the current price for the next few months. This investor wishes to generate income while maintaining her position. In this example, our second investor would sell a call option based on the assumption it would go unexercised and she could generate some premium income while holding the equity position for long-term appreciation. As a further example, here is a version of a typical transaction, using real numbers:

Buying a Call: Scenario 1: Equity XYZ is trading at $500/share. Buyer A, believing that the market value of the equity will rise substantially, buys a call on the equity with a strike price of $500 and pays $20 (for simplicity we are assuming the $20 payment is inclusive of premium and all fees). Suppose, then, that the value of the underlying equity stays above the strike price throughout the life of the option, ultimately rising to $600 on the expiration date. At this point Buyer A will exercise the option, for a profit of $80 ($600 - $500 - $20).

Equity Options

Scenario 2:

Listed equity options are some of the most prevalent and simplest options available to investors.

Writer A has purchased the $500 call for $20, but the market has declined to $400 by the expiration date. Buyer A will let the option expire worthless and will lose only the $20 premium paid for the option rather than the $100 that an outright owner of the equity security would have lost.

These are options on shares of individual equities, and are sold as standardized contracts containing 100 shares of the underlying equity. Realized gains or losses on exercised options are represented as the difference between the price of the underlying asset at the time the option is exercised and the strike price of the option net of the purchase price of the option and any fees paid (such as brokerage fees). As an example, suppose an investor believes the value of an equity security will increase substantially in the market, but thinks there is a substantial amount of risk involved and does not want to take the risk of buying the security outright. He may choose to buy a call option on the security instead, thus limiting his risk to the premium paid while maintaining the opportunity to profit from a big increase in the stock’s value. Let’s assume there is also a second investor already

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Selling a Call: Scenario 1: Writer B owns equity XYX with a market price of $500 per share. Believing that the market value of the equity will remain around that level for the next few months, she sells a call on the equity with a strike price of $500 for $20 (again, we are assuming the $20 is inclusive of all fees, as well as the cost of the contract). On the expiration date, the market value of the equity is $497, and the call goes unexercised. Since the writer does not have to sell her shares of Equity XYZ to the option buyer, she has a net realized gain of $20 on the option.

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Scenario 2: Writer B has sold the call on equity XYZ for $20, but the stock price rises to $600 and the buyer exercises the option, forcing Writer B to sell her shares of equity XYZ at the strike price of $500. Writer B has an opportunity loss of $80, because she sold equity XYZ at $500 when the market price was $600, but she received premium of $20 ($600 - $500 + $20).

Index Options Options on indexes give the holder the right to buy or sell the value of the underlying index rather than a physical underlying asset. While index options may seem convoluted in theory, they actually function in a manner that is almost identical to an equity option. A key difference to be aware of is that the seller of an index contract does not physically own the underlying index. As such, the option would be cash settled rather than physically settled.

Types of Settlement Settlement on options depends in part on the type of underlying asset. Options with tangible underlying assets such as equities, futures, and currencies are settled for either cash or delivery. Cash-settled options allow the owner of the option to be paid the cash difference between the current market value of the underlying asset and the strike price of the option. Index options are always cash-settled since the writer of the option does not actually own the underlying index. Delivery-settled options allow the holder to require that the writer accept physical delivery of the security from the holder (in the case of puts), or that the writer physically deliver the security to the holder (in the case of calls).

Accounting Treatment While the trading and structure of options is relatively straightforward, there are some complex accounting implications to consider when investing in options. Insurers have two ways of accounting for options: hedge and fair value. The qualitative nature of determining the effectiveness of

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a hedge requires a greater degree of manual intervention by the individual or firm preparing the financial statements, naturally making it much more difficult to automate. Conversely, fair-value accounting for options behaves much like accounting for equities in a GAAP trading strategy, is quite simple from a reporting standpoint, and can be easily automated. For GAAP and IFRS purposes, the changes in fair value during the holding period flow through net income. For statutory purposes, these changes flow through unrealized valuation gain/loss, ultimately affecting surplus and other comprehensive income, and delaying the recognition of income. The majority of insurers, both large and small, choose to use only the fair-value approach when accounting for their derivative exposure because hedge accounting is completely voluntary. This is an especially important distinction when managing options, for two main reasons. First, most small-to-medium-sized insurers use an income generation-based investment strategy in conjunction with an equity portfolio. This investment approach is not considered an effective hedge strategy, and therefore hedge accounting becomes inapplicable. Second, hedge effectiveness testing (which is required for treatment of the derivative under hedge accounting) is difficult to complete and requires arbitrary judgment on behalf of the individual or firm preparing the statements. Because there is really no standard as far as how an individual or firm classifies the effectiveness of a hedge, this type of accounting carries a large amount of audit risk for what typically results in nonmaterial differences. In short, the cost/benefit payoff of hedge accounting is not worth the headache for most insurers.

Regulatory Reporting Implications The applicable NAIC guidance for derivatives can be found in SSAP 86. The guidance focuses on the three categorizations of applicable derivative strategies: hedging, income generation, and replication. The NAIC requires that options be reported on schedule DB Part A of an insurers’ filings. Quarterly holdings and annual disposals and holding reports must be disclosed. The DB reports can be difficult to automate, given the level of subjectivity and strategy-based decisions that need to be made. Clearwater’s ability to automate the reconciliation and general ledger accounting, along with its intuitive interface, gives options investors the flexibility where they need it and the automation that eases the scalability concerns with this asset class.

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Key Considerations Investors looking to protect against market swings, as well as those pursuing income generation strategies, might consider options as a valuable addition to their portfolios. It is important to note, however, that while options can generate high yields and provide protection against market fluctuations, the potential for significant losses means these instruments may not be suitable for all investors. Investors evaluating options for their portfolio need to consider their own tolerance for loss, as well as how much of their portfolio they are willing to tie up if selling a covered call. It is also important to consider what mechanisms are in place when evaluating outstanding positions: • Are daily reports available to evaluate the effectiveness of a strategy and manage the portfolio? • Is there constant communication with the investment manager to ensure written options are covered? • What is the most appropriate strategy for your portfolio?

How Clearwater Streamlines the Options Process • Aggregates and reconciles disparate sources of data • Automates data reconciliation, security modeling, and general ledger entries • Provides accounting and regulatory reporting expertise on unique strategies and reporting requirements • Provides detailed accounting, performance, and risk reports based on an integrated, robust, and flexible accounting engine • Provides regulatory reporting in a flexible yet scalable way to quickly and efficiently produce quarterly and annual filings

For more information on how Clearwater can help you integrate and simplify your investment analytics, contact a Clearwater professional at [email protected].

• Do you have systems in place to handle the complex accounting? • Are your internal accounting systems capable of handling different options configurations?

About Clearwater Analytics Clearwater Analytics® is the leading provider of web-based investment accounting, reporting, and reconciliation services for corporate treasuries, insurance companies, and investment managers. Clearwater aggregates, reconciles, and reports on over $1.2 trillion in assets across 25,000+ accounts daily. For over a decade, Clearwater has helped insurance clients such as CopperPoint Mutual Insurance Company, C.V. Starr, Group Health Companies, The Main Street America Group, Savings Bank Life Insurance Company of Massachusetts, The Warranty Group, and Wilton Re streamline their investment and accounting operations. Clearwater remains committed to continuous improvement of the solutions we are providing to current clients, while encouraging prospective firms to rethink how they approach their investment accounting and reporting challenges.

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