The Basics of Derivatives for Trust and Estate Lawyers: Puts, Calls, Collars and Forwards

• Publication year: 2003
• Author: by James B. Ellis, Esq.

THE BASICS OF DERIVATIVES FOR TRUST AND ESTATE LAWYERS: PUTS, CALLS, COLLARS AND FORWARDS

by James B. Ellis, Esq.^*

The use of derivative instruments is increasingly common among wealthy investors. The last decade saw tremendous growth in wealth among company founders, entrepreneurs and corporate executives holding large blocks of low basis stock. Moreover, donors have funded trusts with concentrated stock positions, leading fiduciaries to consider the duty to diversify along with the realities of previous growth in securities valuation, market volatility, the market downturn of the last few years, and concerns regarding taxes and costs. As a result, we are seeing an increase in the creative use of derivatives in trust and estate planning. For example, collars can protect value in trusts or estates that hold blocks of stock that cannot be sold. Accordingly, in light of their clients' changing needs and demands, trusts and estates attorneys must be familiar with the basics of common derivatives, as well as their income and transfer tax implications.¹

I. WHAT IS A DERIVATIVE?

Generally, a derivative is a financial instrument whose value is determined by reference to another financial instrument, investment, security or product. The Uniform Principal and Income Act defines a derivative as:

[A] contract or financial instrument or a combination of contracts and financial instruments which gives a trust the right or obligation to participate in some or all changes in the price of tangible or intangible assets or group of assets, or changes in a rate, an index of prices or rates, or other market indicator for an asset or a group of assets.²

Further, the official comment states that:

"Derivative"[which includes futures, forwards, swaps, and options] is a difficult term to define because new derivatives are invented daily as dealers tailor their terms to achieve specific financial objectives for particular clients. Since derivatives are typically contract-based, a derivative can probably be devised for almost any set of objectives if another party can be found who is willing to assume the obligations required to meet those objectives.³

A. Common Forms of Derivatives

1. Options

Essentially, an option is the right to buy or sell an underlying asset at a specified price for a fixed period of time. As will be outlined below, options are the lynchpin of many derivative structures.

a. Equity Option

As its name implies, the equity option is an option on shares of individual stocks, small groups of stocks or stock indices. Most equity options are "exchange traded options" trading on the New York, Philadelphia, American and Pacific stock exchanges and the Chicago Board of Exchange. Listed options expire not more than nine months from the date granted on the third Friday in the expiration month. Many sophisticated derivatives transactions, for example, cashless collars, are written directly for investors by financial institutions as the counterparty. These are non-exchange traded or OTC options and typically have terms ranging from nine months to ten years.

The fundamental difference between exchange-traded and non-exchange traded options is their liquidity. Either party to an exchange-traded option can liquidate his or her position by entering into a closing transaction, writing or purchasing a traded option position thereby offsetting the position held. Terminating non-exchange traded options, however, requires an agreement and transaction between the option holder and the counterparty.

b. Non-equity Option

A non-equity option is any option that is not an equity option. Examples include options on commodities, futures contracts, debt instruments and foreign currencies.

c. Index Option

An index option is a cash-settled option whose underlying instrument is an index, for example, the S&P 500, Value Line, Dow Industrials and other similar major market indices.

d. Put Option

The holder of a put option has the right, but not the obligation, to sell the underlying asset at the specified exercise or strike price for a fixed period of time. The purchaser of a put pays a premium to the writer for granting the option. The put increases in value as the value of the underlying interest decreases.

A put protects its purchaser from a decrease in the price of the asset (e.g., shares of stock), essentially acting as insurance, without having to sell the stock, realize taxable capital gain or lose voting rights and any dividends. The stock holder usually settles a put with cash rather than selling shares at maturity, and receives

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the difference between the strike price and final stock price. The stock holder keeps appreciation potential, dividends on stock, and voting rights and retains the ability to borrow against the hedged position.

The writer of a put option generally seeks to earn premium income, and is exposed to a decline in value of the underlying interest. The maximum profit is the premium income received; technically loss is unlimited (although it is limited to the difference between the strike price and a $0 per share price). Investors who are unwilling to purchase stock at the current market value can write or sell a put with a lower exercise price to acquire the stock at a lower price.

Example:	Equity Put Options
Stock Price:	$ 100
Put Strike:	$ 90
Term:	One Year
Premium:	$ 5

Stock Price at Maturity	Put Value	Put Premium	Portfolio Value
$75	$15	$(5)	$85
100	0	(5)	95
125	0	(5)	120

(Put Value = Max [Put Strike - Stock Price at Maturity, 0]) (Portfolio Value to Stockholder = Stock Price at Maturity + Put Value + Put Premium)

e. Call option

The call option is a right, not an obligation, to buy the underlying asset (e.g., shares of stock), at the strike price for a fixed period of time. Purchasers of calls pay a premium to the writer for granting the option. Typically, if the market value of the stock falls below the call strike price, the holder will allow the call to expire unexercised.

There are two types of calls, covered and uncovered (or naked). A covered call involves the purchase of a share of stock with a simultaneous sale of a call on that stock. The position is covered because the potential obligation to deliver the stock is covered by the stock already held in the portfolio. Generally, the rationale is to increase income to the stock holder who intends to sell the stock at the exercise price. The stock holder sells the call for an up-front premium, and agrees to forfeit the potential appreciation in the stock above a predetermined strike or exercise price ("call strike") until a future date. The premium realized by the stock holder produces benefits in a high volatility environment, enhances the yield return of the stock, and provides partial downside protection. The stock holder caps potential return on the stock and keeps dividends and voting rights on the stock during the term of the contract. At maturity, if the stock price is greater than the call strike, the stock holder pays the difference. If the stock price at maturity is equal to or less than the call strike, the call expires worthless.

Alternatively, in an uncovered or naked call, the seller or writer does not own the underlying asset. Generally the writer does not want these calls to be exercised because exercise means the market value has increased and the writer must buy the underlying asset at a price likely to be above the exercise price for the call.

Generally, buyers purchase call options with the expectation that the underlying interest (and thus the option) will increase in value. The buyer benefits from an increase in value of the underlying interest with a much smaller outlay of cash than if purchasing the instrument itself. Any loss can never exceed the premium paid for the option. On exercise, the holder must pay a strike price to the option seller for the underlying interest, and gives up any future increases in price during the remainder of the contract.

The writer or seller of the call is obligated to deliver either the underlying interest (if physically settled) or cash equal to the difference between strike price and market price (if cash settled), if and when the call is exercised.

Example:	Equity Call Options
Stock Price:	$ 100
Call Strike:	$ 120
Term:	One Year
Premium:	$ 5

Stock Price at Maturity	Call Value	Call Premium	Portfolio Value
$75	$0	$5	$80
100	0	5	105
150	(30)	5	125

(Call Value = Max [Call Strike - Stock Price at Maturity, 0]) (Portfolio Value to Writer of Call = Stock Price at Maturity + Call Value + Call Premium)

f. European v. American-Style Options

A European-style option may be exercised only on the expiration date. An American-style option may be exercised at any time between date of purchase and the expiration date.

g. Option Glossary⁴

• "Strike or exercise price": The strike price or exercise price is an agreed upon price to acquire the underlying asset.
• "Long and short positions": A long position is ownership of an underlying asset. A long position can also refer to the holder of an option who has the right to buy or sell the underlying stock. The writer or seller of an option who has the potential liability is short on that position.

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• "In-the-money/out-of-the-money": If an investment is in-the-money, the investor has profit built into a transaction as of any given measurement date. Out-of-the-money is the opposite. At-the-money means that the strike and market prices are identical.
• "Intrinsic value": The amount by which an option is in-the-money.
• "Time value": In addition to its intrinsic value, an option has value related to the length of time remaining until its expiration. A portion of the option premium pays for this time value.

2. Collars

A collar is an option strategy that brackets the value of an asset. An investor who buys a put option is protected from significant decline in a large stock position by establishing a "floor" for the stock's value. If the investor is...