​Morgan Stanley

BGE University Presentation (Part 1) -

​Options in Finance
​Csaba Bőde
26 October 2023
Table of Contents

Introduction
Embedded options – Structured notes
AT1 Bonds
OTC contracts – Collateral, Re-hypothecation, CTD Option
Basket Rebalance Rights
Greenshoe/Overallotment

MORGAN STANLEY PRESENTATION CONFIDENTIAL 2

Introduction – value in optionality

​Forward ​Option

​Bilateral obligation ​Obligation one side – optionality other

​Symmetric ​Asymmetric

​Fair Value both positive and negative ​No/Limited downside for the buyer – fair value positive

​Zero value at inception ​Value at inception – compensate the buyer

140 40

120
Value

Value 20

100

80 0
80 90 100 110 120 130 140 80 90 100 110 120 130 140
Stock Price Stock Price

MORGAN STANLEY PRESENTATION CONFIDENTIAL 3

Structured Notes

• Bond combined with derivatives

• Formula based return

• Credit risk of the issuer

• Market risk of the underlying instruments

• Note - buyer long or short optionality

– Reverse convertible

• Additional optionality – Volume flex

– Right to increase issuance size at the original price

– Option on the structured note

MORGAN STANLEY PRESENTATION CONFIDENTIAL 4

Reverse Convertible – redemption at maturity

Without Barrier protection With Barrier protection

120 120

100 100

Redemption Value
80 80
Redemption Value

60 60

40 40

20 20

0 0
0 20 40 60 80 100 120 140 0 20 40 60 80 100 120 140
Stock Price Stock Price

MORGAN STANLEY PRESENTATION CONFIDENTIAL 5

AT1 Bonds

• Issued by Banks

• Contingent convertibility

• Converts to Equity at a Basel Tier 1 Capital ratio threshold

• Shock absorbing feature

• Buyer compensated by higher coupon

• 50-100 bn USD market before 2023

MORGAN STANLEY PRESENTATION CONFIDENTIAL 6

Margining/Collateral Derivatives

• Derivatives transactions – counterparty risk.

– Exchanges: Central Counterparty, Clearing, Margining

– OTC: Master Agreement, Collateral

• Option to deliver margin/collateral

– Different currency

– Instrument other then Cash

• Government Bond
• Letters of Credit
• Stock, etc

• Haircut applied based on the liquidity of the collateral

• Value for the collateral posting counterparty

MORGAN STANLEY PRESENTATION CONFIDENTIAL 7

Derivatives – cheapest to deliver

• Futures contract – contract specification

– Physical vs cash settlement

– Contracts allow delivery of a variety of eligible securities

– Commodities – contract specification regarding quality

• Option to deliver cheapest security

– Priced in at some markets

MORGAN STANLEY PRESENTATION CONFIDENTIAL 8

Derivatives – Re-Hypotecate

• Option to use collateral for own purposes

– Funding costs associated with collateral/margin

– Collateral re-use as collateral in other derivatives contract

• Impacts the original derivatives price

– Counterparty compensated with higher coupon, lower interest rate etc.

• Associated credit risk

MORGAN STANLEY PRESENTATION CONFIDENTIAL 9

IPO – Greenshoe/Overallotment

• IPO – Underwriters to sell more shares

– Underwriter short position to hedge

– Stabilize the price

– Oversell the IPO – stabilize both way

• Reverse Greenshoe

– Stabilize by reducing market pressure

MORGAN STANLEY PRESENTATION CONFIDENTIAL 10

Literature

• The xVA Challenge: Counterparty Credit Risk, Funding, Collateral and Capital (The Wiley
Finance Series) Jon Gregory – Wiley

• https://www2.deloitte.com/content/dam/Deloitte/ch/Documents/risk/deloitte-ch-en-breakin
g-down-xva-allocation.pdf

MORGAN STANLEY PRESENTATION CONFIDENTIAL 11

​Morgan Stanley
BGE University Presentation (Part 2) -
​Corporate Equity Products
​Csaba Bőde
26 October 2023
Corporate Equity Products
Tailor-made trades serving specific client needs and presenting unique valuation risk
Client is a big corporation/investor:
• Financing/Refinancing: The client looks to purchase a
sizeable holding in a stock or aiming to monetize on
existing holdings
• Returning Shareholder Value: The client looks to buy
back shares instead of paying dividends.
• Convertible Bond Hedge: The client wants to avoid
dilution effect from its convertible bond issuance
MORGAN STANLEY PRESENTATION
Risk is tied to a big corporation:
• Concentrated Gap Risk: The risk that a sudden
drop in share price can push the collateral value
below the loan value even with all the loan-
specific triggers meant as safety features.
• Concentrated Kappa Risk: The kappa of the
option way exceeds regular traded volume.
• Concentrated Volatility Skew Risk: The skew risk
way exceeds the regular traded volume.
CONFIDENTIAL 13
Equity Margin Loan (EML)
EML in the news

• https://www.euromoney.com/article/b174wy2qd17rlt/will-steinhoff-margin-loan-fall-out-mark-end-of-easy-money
• https://www.reuters.com/business/musks-bankers-mull-new-tesla-margin-loans-slash-twitter-debt-bloomberg-news-2022-12-
08/

MORGAN STANLEY PRESENTATION CONFIDENTIAL 15

EML - what it is after all?

PRODUCT Margin loans are secured primarily by concentrated positions in listed equities (or instruments
DESCRIPTION convertible or exchangeable into equities or unlisted equities), commonly without additional recourse
to the client. Initial loan-to-value (“LTV”) typically ranges from 30-50%, with large drops in stock price
required to trigger margin calls.

COMMON • Overcollateralization: There is typically one equity name pledged as collateral. Without the
ADDITIONAL diversification of a typical stock portfolio, an Equity Margin Loan requires significant over-
FEATURES collateralization
• Non-recourse: In case of default, the issuer can only take control of the pledged collateral for
recovery.
• Loan-specific triggers: Each loan is unique as to the existence and levels of any specific triggers
for margin call, issuer early termination etc.
• Loan Put-ability: Each loan typically allows the borrower to repay the loan before the stated
maturity
• Use of Proceeds: buying specific asset or loan refinancing using already owned asset

MORGAN STANLEY PRESENTATION CONFIDENTIAL 16

EML mechanics

Collateral
account

Seller
Lender
Borrower Borrower SPV

Floating rate + Fix

Spread
Cash

Underlying Asset

MORGAN STANLEY PRESENTATION CONFIDENTIAL 17

EML - what it is after all? (cont’d)

CLIENT The client looks to purchase a sizeable holding in a stock or aiming to monetize on existing holdings
MOTIVATION and refinance outstanding debt/finance other business endeavours.

SPECIFIC • Undiversified collateralization: There is typically one equity name pledged as collateral. Without
VALUATION RISK the diversification of a typical stock portfolio, an Equity Margin Loan requires significant over-
collateralization
• Gap Risk: A sudden drop in share price can push the collateral value below the loan value
even with all the loan-specific triggers meant as safety features

MORGAN STANLEY PRESENTATION CONFIDENTIAL 18

(Accelerated) Share Repurchase Program - ASR
ASR in the news

• https://fortune.com/2023/04/17/how-much-will-apple-spend-on-stock-buybacks-earnings-90-billion/
• https://finance.yahoo.com/news/nokia-corporation-repurchase-own-shares-180000728.html

MORGAN STANLEY PRESENTATION CONFIDENTIAL 20

ASR - what it is after all?

PRODUCT A share repurchase is a transaction whereby a company buys back its own shares from the
DESCRIPTION marketplace. The company buys shares directly from the market or offers its shareholders the option
of tendering their shares directly to the company at a fixed price.

COMMON • Initial Payment and Delivery: On the “prepayment date”:

ADDITIONAL
• the company pays to the dealer a prepayment amount equal to the aggregate dollar amount
FEATURES
that the company commits to repurchase shares pursuant to the ASR transaction; and
• the dealer delivers to the company a number of shares of company common stock equal to a
specified percentage (typically 80-85%)1 of the number of shares determined by dividing the
prepayment amount by the most recent closing market price of the company’s common stock
prior to execution.
• Early Termination Option: A typical ASR transaction (and the averaging period for purposes of
determining the final price to be paid by the company for shares of common stock repurchased
pursuant to the ASR transaction) has a scheduled termination date, which may be accelerated by
the dealer at any time after a specified minimum term.
• Final Price: The final price per share to be paid by the company for shares of common stock in an
ASR transaction will generally equal (i) the arithmetic average of a published daily volume weighted
average price (VWAP) of the company’s common stock over the averaging period minus (ii) a
specified discount.
• True-Up/Final Delivery: If, as expected, the total number of shares that could be purchased by the
company at the final price per share is more than the number of shares initially delivered by the
dealer to the company, the dealer will be required to deliver additional shares to the company to
cover the difference.

MORGAN STANLEY PRESENTATION CONFIDENTIAL 21

ASR mechanics
Cash Collateral at Inception
Cash: at discount to VWAP

Cash as Shares Returned

Company Investment Bank Stock Lender

Shares Returned

Shares: cca. 80% delivered at Inception Shares at Inception

MORGAN STANLEY PRESENTATION CONFIDENTIAL 22

ASR - what it is after all? (cont’d)

CLIENT The company looks to buy back some of its shares from the open market to give back shareholders
MOTIVATION some value. The ASR provides flexibility and better pricing than traditional open market programs.
Alternative could be dividend payment, which ASR has a tax advantage over.

SPECIFIC • Acceleration feature: It enhances the optionality the investment bank has in executing the
VALUATION RISK program.
• Concentrated Kappa Risk: The kappa of the option way exceeds regular traded volume.

MORGAN STANLEY PRESENTATION CONFIDENTIAL 23

Corporate Call Spread
Call Spread (CS) in the news

• https://edition.cnn.com/2021/11/16/investing/jpmorgan-tesla/index.html
• https://finance.yahoo.com/news/onsemi-announces-proposed-private-offering-224000539.html

MORGAN STANLEY PRESENTATION CONFIDENTIAL 25

CS - what it is after all?

PRODUCT Also known as Convertible Bond Hedge + Warrant or Call Spread Overlay. Technically it is a
DESCRIPTION combination of an OTM long call and an even more OTM short call/warrant tied to a convertible bond
issuance (client’s perspective).

COMMON • Convertible Bond: The client issues a convertible bond providing the optionality to bondholders to
ADDITIONAL convert the bond into shares of client at a higher than current share price (conversion price). If no
FEATURES conversion, the bond acts as a regular corporate bond.
• Long Call Strike: The strike of the long call equals with the conversion price of the CB.
• Short Call Strike: The strike of the short call/warrant is higher than the conversion price of the CB.
• Tranched Maturity: The maturity of the long call coincides with the conversion period of the CB
over a couple of months (usually 4-5-6 years after issuance).

MORGAN STANLEY PRESENTATION CONFIDENTIAL 26

CS mechanics
Issues CB at $100 conversion price
Sells a call at $100 strike

Exercises the call at $100 Converts CB at $100

Investment Company CB Holder
Bank

Delivers a share from the

market

Exercises the call at $120 Issues a new share for the

CB

Issues a new share

Sells a call at $120 strike Buys CB at par - yield

• Share price at $80 at the time of issuance

• Share price above $100 in the conversion period

• Share price above $120 in the conversion period

MORGAN STANLEY PRESENTATION CONFIDENTIAL 27

CS - what it is after all? (cont’d)

CLIENT The company looks to balance share dilution and the yield at which they can issue the CBs. The
MOTIVATION conversion price still attractive enough to keep the yield low could result in unwanted early dilution
impact. Hence the company buys a call with strike being equal to conversion price and sells a warrant
to the bank with a strike price at which they could accept dilution.

SPECIFIC • Concentrated Kappa Risk: The kappa of the option way exceeds regular traded volume.
VALUATION RISK • Concentrated Skew Risk: The skew risk of the options way exceeds regular traded volume.

MORGAN STANLEY PRESENTATION CONFIDENTIAL 28

​Thank you for your attention!
Literature

• https://www.amttraining.com/knowledgebank/financing/call-spread-overlays/

• https://www.investopedia.com/terms/s/sharerepurchase.asp

• https://www.whitecase.com/insight-our-thinking/navs-meet-margin-loans-rise-single-asset-financings

MORGAN STANLEY PRESENTATION CONFIDENTIAL 30