http://www.fisn.com/CDalternatives.htm The street is issuing this paper that pays a very high rate of interest 10-19 % a year, but is actually a modified bet on stock. Whenever I analyze these I can't seem to figure out a decent hedge with options, which makes sense since they are probably marking up the existing prems big time. Someone want to tackle this and see if theres a way to game them?
I presume you are talking of fixed rate exchangables? It is a fairly straight forward equity linked note. In it's simplest case, if the stock dropped below todays level, you get stock, otherwise, you get cash + interest. In short, you are selling ATM puts for cheap, either in a simple european form: or in a form of american barrier: Sometimes, you are selling OTM american barrier Now, hedge-wise, american barriers are pretty well hedged by simple Europeans, they are long vega and long skew.
These have a protection feature by % of the stock price, that varies with the issue. Certainly complicates analysis. Take a look at one of them and see if you can figure out how 'cheap' you are selling the put vs the true market.
How would % of the stock price be different from the actual dollar amount given that you know the initial price of the stock? These really are straight forward, unless I am missing something - do you have a term-sheet for one of these handy? Anyway, are you planning buy these notes and hedge them using some alternative methods?
Margin requirements aside, no upside, limited downside translates into: +u - (ATM LEAP) c + (DOTM LEAP) p or - (ATM LEAP) p + (DOTM LEAP) p .