Assignment# Submitted by: Faheem Aslam, Reg# 2011750729 11st November 2010 Option Shock in Korean Stock Market

Questions: What are the future challenges and how to prevent from such shocks in future? What is the Derivative Expiration Day Effect on stock market? What are the main implications of this option shock in the field of finance? What are the future challenges and how to prevent from such shocks in future?
Future challenges Balance between derivative market vitalization and stabilization must be one of the important future challenges. To make derivative markets stable, re-regulation is unavoidable. On the other hand, to make derivative markets vital, deregulation is favorable. Although Korea has enjoyed the most vital derivative markets in the world, the authorities and market participants should reconsider the side effects of the weak regulations on the derivative markets in reality. How to address the future challenges? Market stabilization can be achieved by regulating the speculative hands and preventing market manipulation by them. Since usual market participants are reluctant to take part in the unstable market and the market is more vulnerable to speculative hands and being under control of them, regulation should put more weight on stabilization than vitalization. Giving more incentives to NPS fund or other Korean institutional investors in order to prevent the market from the threat of speculative foreigner funds is another way to address the challenge. To secure the market from the speculative and massive foreigner funds, NPS fund and other Korean institutional investors roles are important. By modifying the existing regulation which doesnt give any merits for them to take part in the derivative markets which is monopolized by foreigner funds, they can make the market stable when the unexpected speculative threat is occurred. How do other financial markets prevent similar incidence? In Hong Kong security and derivative markets, they benchmark the price in which the index movement is reflected by every 5 minutes as a settlement standard until market close on option maturity day. In Korea, in case of ELW, they settle them up with the 5-days average closing price including maturity day. If the option market price were run in this way in Korea, the option shock would not be occurred.

What are the Derivative Expiration Day Effects on stock market? The impact of expiration of derivatives contracts on the underlying cash market on trading volumes, returns and volatility of returns has been studied in various contexts. Research shows that trading volumes were significantly higher on expiration days and during the five days leading up to expiration days (expiration weeks), compared with nonexpiration days (weeks). Even though the 1987 stock market crash in the United States was not attributed to futures and options trading per se, there was some concern among regulators that programme trading and index arbitrage that link the derivatives and cash markets to each other may have exacerbated the crisis (Edwards and Ma, 1992, Chapter 11) By its very nature, arbitrage between the cash and (especially) futures markets require investors to unwind positions in the derivative market on the day of expiration of contracts, in order to realize arbitrage profits. (Deutsche Bank) The consequent increase in the number of large buy and sell orders, and the temporary mismatch between these orders, can significant affect prices and volatility in the underlying cash market. Not surprisingly, regulators around the world have responded with a number of measures aimed at reducing price volatility on account of the so-called expiration effect of index derivatives.

Prices in the cash market are somewhat depressed a day before the expiration of the derivatives contracts, and they strengthen significantly the day after the expiration.

The importance of expiration day effects on the cash market to regulators has, in turn, generated interest on such effects within the research community. As a consequence, the impact of expiration of futures and options contracts on the underlying cash market has been examined in a number of contexts for example Chamberlin, Cheung and Kwan (1989) found significant impact of derivatives contract expiration on both mean returns and volatility.

Vipul (2005) uses data on 14 equity shares to examine expiration day effects in the Indian stock market. The underlying stocks are selected in a manner that reflected a range of different liquidities for the associated derivative products; the ratio of turnover in the derivatives market to turnover in the underlying cash market ranged from 55 percent to 344 percent. Thereafter, the price, volatility and volume of the underlying shares in the cash segment of the exchange 1 day prior to expiration (of derivatives contracts), on the day of expiration and 1 day after expiration are compared with the corresponding values of these variables 1 week and 2 weeks prior to the expiration days. The study concludes that prices in the cash market are somewhat depressed a day before the expiration of the derivatives contracts, and they strengthen significantly the day after the expiration.
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Finally, volumes are higher on expiration days than on the benchmark non-expiration days. Comparative Trading: Expiration day vs. control. Panel A: Trades (in millions) Panel B: Volume (Rs. In Billion)

Results indicate that trading volumes were significantly higher on expiration days and during the five days leading up to expiration days (expiration weeks), compared with nonexpiration days (weeks). Results also shows significant expiration day effects on daily returns to the market index, and on the volatility of these returns. Finally, our analysis indicates that it might be prudent to undertake analysis of expiration day effects (or other events) using methodologies that model the underlying data generating process, rather than depend on comparison of mean and median alone. __________________________________________________________________________
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Q#2: What are the main implications of this option shock in the field of finance? The 11st November 2010 Option Shock in Korean Stock Market demonstrated several important issues in finance. Implication to Board of Directors: The risk oversight function of the board of directors has never been more critical and challenging than it is today. In the context of the current global financial crisis and the swooning global economy, companies now face risks that are more complex, interconnected and potentially devastating than ever before. Risk from the financial services sector has contributed to large-scale bankruptcies, bank failures, government intervention and rapid consolidation. Companies in nearly every industry have suffered from the effects of a global paralysis in the credit markets, sharply reduced consumer demand and extremely volatile commodity, currency and stock markets. In addition, the public and political perception that undue risk-taking has been central to the breakdown of the financial and credit markets is leading to an increased legislative and regulatory focus on risk management and risk prevention. In this environment, boards and companies must be mindful of the possibility that courts will apply new standards, or interpret existing standards, to increase board responsibility for risk management. Implication to risk management: Short Strangle (Sell Strangle) is like an aging mountain climbing rope. It will still work for a while, but when it finally gives out, you're dead. When a huge event occurs after market hours and the index/stock opens up outside your range. Limited risk strategies like iron condors and such a slightly painful but do little damage. Naked strangles will hit you like an earthquake in those situations. 99% of the time you'll be able to manage the strangle by watching the market closely. <1% of the time you won't. Unfortunately that tiny percentage, possibly even just a one-time event, can end your trading career.
Short Strangle (Sell Strangle) is like an aging mountain climbing rope. It will still work for a while, but when it finally gives out, you're dead.

Remember, even 3 standard deviations only covers 99.7% of outcomes. That means that .3% of outcomes are NOT covered at 3 SDs. What kind of markets do you think they will be? That's the other problem with strangle strategy. Take your 1700/2000 strangle. You may have a mental stop to close or roll
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at 1700 (or whatever), but what happens when the market drops from over 1800 to 1700 in the space of 2 minutes? Assuming you're not taking a bathroom break, or making a sandwich or something do you have the nerve to simply and immediately make the trade? Hesitate 15 seconds to figure out what's going on and the market is down another 30 points. Place your order at the market and you'll probably get a good case of slippage shock. Place a limit order and you'll probably either not get filled or spend the next 10 minutes moving your limits. What if they halt trading before you get out? It is essential that all companies define in a clear and unambiguous way limits of the financial risks that they can take. They should then set up procedures for ensuring that the limits are obeyed. It is particularly important that companies monitor risks carefully when derivatives are used. The argument here is not that no risks should be taken. But the sizes of the positions that can be taken should be limited and the systems in place should accurately report the risks being taken. Many strategies can survive isolated incidents like this. Short strangles can't. They're such a low profit-high risk type of trade that a single such incident can wipe out years of profits- if not knocking the trader out of the market altogether. Mental stop is fine, but it doesn't protect you from overnight gaps. Iron condor (or any other similar strategy), on the other hand, gives you protection no matter what happens overnight. So as always you have a trade-off between risk and reward. Effectively, what you do is give back some of your short strangle premium to buy an insurance in the form of a long strangle. And if ever used, only one leg of this 'insurance' will be exercised. Knowing that you watch the market daily and can react quickly to changes in the underlying, why waste money on static hedge and not implement a dynamic hedging strategy? E.g., limit your downside risk the same way an iron condor. Unlimited Risk Large losses for the short strangle can be experienced when the underlying stock price makes a strong move either upwards or downwards at expiration.

The formula for calculating loss is given below: Maximum Loss = Unlimited Loss Occurs When Price of Underlying > Strike Price of Short Call + Net Premium Received OR Price of Underlying < Strike Price of Short Put - Net Premium Received Loss = Price of Underlying - Strike Price of Short Call - Net Premium Received OR Strike Price of Short Put - Price of Underlying - Net Premium Received + Commissions Paid

Implication to asset managers: In many of situations including 11 Nov option shock, the asset managers had become selfsatisfied about the risks they were taking because they had taken similar risks in previous years and made profits. But asset managers should keep in mind that 99% of the time you'll be able to manage the strangle by watching the market closely. <1% of the time you won't. Unfortunately that tiny percentage, possibly even just a one-time event, can end your trading career and the penalties for exceeding risk limits should be just as great when profits result as when losses result. Implication to investors: Do not underestimate the most unlikely events. Follow thoroughly what the regulation says. Beware when everyone is following the same trading strategy or market consensus. Do some critical research on the different trading strategies and choose which one is the best one that will fit your financial goals and personal style. Implication to regulatory agencies: Making laws and implementation of the law are two different things. Law should b followed by it true spirit not in words. Regulators should tighten regulations and strengthen their oversight to prevent international hedge funds or other speculative capital to make their way to the local market. It is also important to put an effective mechanism in place to ensure all investors, foreign or local, play fair. Regulators also should verify and rectify their regulation systems to make them work properly.