PE Toolbox: Equity Ratchets
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Cliquets are one of the most popular structures traded. These are also known as ratchet options due the resetting strikes equity ratchet option the structure. This resetting strike feature is what makes cliquet structures unique as they create an exposure on the forwad skew and vega convexity we'll come back to this.
First lets look at the payoffs of the two commonly traded cliquet structures. Their payoffs are given below:. Cliquets could be viewed as a series of forward starting options. This strategy locks in periodic returns from the underlier unlike the conventional european options. Figure 1 below shows the sample payoffs of this structure under three scenarios and compares it with the payoff of a standard european call.
The returns shown in the figure are periodic say yearly. In the first scenario in which the stock always increases example-in bullish market where the stock ralliesthe normal european call outperforms the cliquet payout. In the second and the third scenario, example-an extremely volatile market especially after a crash equity ratchet option indeed as the second scenario indicates a sort of crash in the first year followed subsequent steady recovery the cliquet outperforms the standard call option.
Because the structure locks in periodic returns which are subject to a floor of 0, the trade picks up only positive periodic performances which could be a strategy employed in volatile markets. Also the investor benefits when the future volatility of the underlier increases. After all, he's been charged for a specific implied volatility, equity ratchet option the realized volatility is infact greated equity ratchet option the expected, he benefits from a wilder equity ratchet option underlier moves.
First lets talk about the vega, both the forward starting options second component and the compound option the third component in the expression above increase in value with increase in volatility.
However since the buyer is actually short the compound option and long the series of forward starting options, the net vega whether positive or negative would be determined by the values of Local Floor and the Global Cap.
For example, if the Local Floor is zero, the buyer is long a series of ATM forward starting options and as we know that the vega for ATM options are the maximum, the first component in the above expression might dominate and the buyer might actually be long vega. The position in the third component the equity ratchet option option is not clear. Likewise, the overall skew position in cliquets is not clear. Hence the overall structure becomes sensitive to the vega convexity. We know caps can be viewed as a combination of long asset and equity ratchet option OTM call options and as we do know that OTM call options are short skew [OTM puts equity ratchet option ITM calls are costlier in the presence of a skew] making the cap structures for the buyer long skew.
As a result the LCGF cliquet structure, is long skew for the buyer. Depending on whether what the values of the local cap and global floor are, the LCGF cliquet structure has exposure to vega convexity. A physicist thinks reality is an approximation to his equations. A mathematician doesn't care.
Risk analysis of Cliquets 3. I have my own problems to solve. I'm never likely to go there. I am just short the profit at the moment.