On April 17, SJ Zaremba and Mengru Zhang of RJA LLC hosted “How and Why We Use Equity Derivatives.” The event was the seventh and final in this semester’s Robert K. Wilmouth Speaker Series, a number of lectures hosted by NDIGI designed to further students’ knowledge of the science and art of investing. The objective of the event was to teach students about various forms of derivatives, their history, and how they are used.
SJ Zaremba is the Director of Sales and Marketing at RJA LLC. There, he specializes in relationship management and equity derivatives. Prior to joining RJA, Zaremba served as a Director at Credit Suisse and started the equity derivatives desk at Prebon Financial Products. He has accumulated over 25 years of firsthand experience in derivatives markets. He attended the Martin J. Whitman School of Management at Syracuse University, graduating with a BS in Finance in 1991.
Mengru Zhang serves as Vice President of the Investment Team at RJA. She leads and actively participates in portfolio analysis, strategy research and financial modeling projects for the firm. She graduated from the University of Hong Kong in 2013 before receiving her Master of Finance from the MIT Sloan School of Management in 2014.
About RJA LLC
RJA was founded in 2009 when three former Yale School of Management professors––Steve Ross, Andrew Jeffrey, and Rick Antle––resolved to bring their academic experience to the investment industry. The firm prides itself on a research-based and data-driven investment approach, and has clients including university endowments, public pensions, and Fortune 100 pensions. RJA has offices in New Haven and Darien, Connecticut. Visit RJA’s website to learn more.
RJA specializes in equity derivatives, and offers their clients three services: an overlay in which an option portfolio is created on top of an equity portfolio to prevent losses in a down market, a volatility risk premium portfolio, which is a systematic option selling program on a monthly basis, and an alpha portfolio, which uses options to create a zero beta, volatility arbitrage strategy.
What are Derivatives?
Though the word indicates a direct connection to the advanced mathematical concept, Zhang articulated that equity derivatives are not nearly as complicated as their name implies. A derivative, she explained, is simply “a financial instrument with a value that is derived from something else.” There are three main types of derivatives: futures, options, and swaps.
Futures, or forwards, are an agreement made between two parties to buy or sell an asset at an agreed-upon price on a certain date in the future.
An option is an agreement in which one party has the right, but not the obligation, to buy or sell an asset at an agreed-upon price on or before a specific date in the future.
The third type of derivative, a swap, is a more recent development. It is an agreement to exchange payments over a period of time. Zhang described it as “essentially a stream of multiple futures packaged into one agreement.”
The History of Derivatives
“If any one owe a debt for a loan, and a storm prostrates the grain, or the harvest fail, or the grain does not grow for lack of water; in that year he need not give his creditor any grain, he washes his debt-tablet in water and pays no rent for the year.”
The above is Law 48 from the Code of Hammurabi––dated to the 18th century BC. Zaremba and Zhang used it to illustrate that derivative securities are far from a new development in the world of investing. In fact, they have existed for the majority of recorded human history.
The modern history of derivatives in the United States began in 1848 with the opening of the Chicago Board of Trade. It is one of the oldest options and futures exchanges in the world.
1973 saw the development of the “Black Scholes Model,” a significant financial theory concept that allows traders to determine an appropriate or fair price for an option. It remains in use today. In 1993, the Chicago Board Options Exchange launched the VIX index, which Zhang described as “a measure of the market’s expectation of future volatility.”
Though the role of derivatives and the methods of their calculation has evolved over the centuries, their defining characteristics are unchanged, and derivatives remain a central component of the investing industry.
What do we use Derivatives for?
Zaremba and Zhang explained that there are multiple reasons firms like RJA use derivatives for their clients. Derivatives mitigate price risk and smooth out cash flow from equity portfolios. They have reduced transaction costs because they are able to “obtain desired market exposure without physically re-allocating capital,” said Zhang. They also “relieve the impact of artificial constraints and regulatory restrictions that come along with investing.”
They stated that derivatives are a great tool for investors to use and are “the basis of many risk management and risk transfer products.” They cautioned, however, that derivatives are by no means “a free lunch.”
“Risk is not eliminated, but transferred,” said Zhang. “Derivatives must be well understood and properly implemented.”
Zhang then led the audience through two in-depth case studies involving equity derivatives. The first was an assessment of the “ABC Public Retirement System” and solving its large funding gap. The second examined volatility as a tradable asset, and made use of both the Black-Scholes model and the VIX index. Using their firsthand experience in the derivatives market, Zaremba and Zhang talked the audience through the studies in detail, allowing all those present to gain a clear insight into the practical application of equity derivatives.