Affordable Housing Bonds, Secured Options and Margin Free Options; Three Innovative Financial Products to Solve a Social Need
Mechanism
The mechanism is essentially a tax on derivative transactions to fund a subsidy for affordable housing.
Have public housing tenants who pay rent.
The rental payments would be packaged into Affordable Housing Bonds (AHBs) contracts
A portion of AHBs are sold to investors while the remaining AHBs are packaged into Equity Like Bonds (ELBs) and sold to investors. In exchange for the AHBs and ELBs, Public Housing Owners (PHOs) would receive the present value of AHBs and the market value of ELBs respectively.
The investors or speculators can then write derivatives based on the ELBs.
These derivatives can either be Secured options, regular options or margin free options.
These derivatives can then be traded.
Trading derivatives will incur a fee and a portion of the fee will be returned to the contract issuers (or PHOs) of the ELBs.
The value of ELBs options will influence the value of ELBs
Equity Like Bonds (ELBs) - value based on AHB, an ELB call option and an ELB put option. The value of an ELB is equal to the AHB plus the value of the call option minus the value of the put option. The strike price of the call and put options used to determine the value of ELBs are equal to the face value of the AHB.
Stakeholders in the mechanism include renters, PHOs (or AHBs issuers), banks (which act as an intermediary), investors, and some form of regulator.
Renters benefit as the supply of affordable housing should increase because a financial incentive exists that encourages the production of affordable housing.
For the mechanism to have its desired outcome of increasing housing supply, the volume of derivatives traded need to be such that the income that PHOs receive is greater than what they would receive if they did not write and sell the contracts. To ensure high derivatives trading volume, I would introduce two new financial derivatives: (1) secured options; and (2) margin free options.
Secured Option (SO) — the writer of an option would have a margin call that is twice the margin call of a normal option. The margin covers their option position in addition to the margin required for the Margin Free option (MFO).
Margin Free Option (MFO) — the writer of a MFO does not need initial margin as this is covered by the SO.
The SO writer will write an option, sell the option, and receive a premium. They will use a portion of the premium to pay the MFO writer, who will write an identical contract to be sold to the SO writer. In exchange for the premium, the MFO writer takes on the risk from the SO writer. The SO writer keeps the difference between the premium they received from the option sale and the premium they paid to the MFO writer. This is a risk-free return.
Providing SOs provides investors seeking a risk free return an incentive to write options on ELBs and this increases trading volume, which increases the number of transactions. This results in greater income for affordable housing producers.
Investors with an appetite for high-risk investments would be attracted to MFOs as they can essentially borrow the margin at lower rates relative to what they would receive from other sources, thereby resulting in greater percentage returns.
Additionally, if returns from SOs are risk free and greater than the prevailing risk-free rate of return, put-call arbitrage opportunities are available to investors.
Banks would benefit from this mechanism as it involves the writing of contracts and trading securities, which they can earn fees from. They would be willing to give up the transaction fee gained from derivative trading as it allows public housing owners to sell contracts that banks can make money from and the writing of the derivatives will also generate the bank fees.
Investors benefit because they have a range of financial securities to invest in: from safe bonds (AHBs) and SOs to riskier ELBs and even riskier MFOs.
Example
Paul lives in a housing commission flat and pays $100 per month in rent. Paul’s rent for the year will be $1,200. Paul’s rent is packaged into a contract that states, at the year’s end, the owner of the contract will receive $1,200. ‘A’ is willing to pay $1,100 today for $1,200 in twelve months’ time. The contract is packaged into an equity like bond in whose value is determined by the bond value added to the call option value subtracted by the value of a put option.
Assume the call option is worth $20 and the put $15, the owner of Paul’s house will receive $1105 today. The investor who purchased the ELB then decides to write a SO based on the contract. The derivative is a secured call option, which states that its owner will have the right, but not the obligation, to purchase the ELB for $1,150. They then sell this contract and receive say $20. In the process of selling the option, they paid a transaction fee, and a portion of that fee was returned to the owner of Paul’s flat. Each time that derivative is traded, the owner of Paul’s flat will receive a portion of the fee. If this adds up to more than $100 over the course of twelve months, the owner will make more money using this mechanism than if they had received rental payments each month (would also have to factor in risk free rate of return as owner could deposit money and receive interest. To reach $1,200 PHOs, would have to make slightly less than $100 from fees).
The margin required to write a secured option is 10% of the bond’s value and is therefore $110. However, to write a secured option, 20% margin is required and so, the upfront collateral is $220. For the secured option, half the initial margin is for the SO contract and the other half is set aside for the MFO. When the writer receives the $20 premium, they pay $17 to the writer of a margin free option. The margin free option writer is essentially borrowing the $10 margin from the SO writer. Assuming the cost of borrowing from the SO writer is less than the cost of borrowing from another entity, the MFO writer receives a lower cost of borrowing in exchange for taking on the downside risk of the SO writer. The SO writer will make a risk-free profit equal to the difference between the premium they receive and the premium they paid the MFO writer. By providing these two derivatives and thereby stratifying option writers by risk appetite, one can increase the trading of derivatives while offering investors products that cater to their varied risk profiles.
The PHOs who supply the ELB will also likely write a secured call option to form the ELB and reduce the downside risk of selling an ELB.
The assumption is that if the volume of derivatives traded is high, then the AHB issuer (that is, PHO) may make greater income through the mechanism than simply receiving rent from tenants. Therefore, if the potential return from public housing is increased, this should increase supply of public housing. Additionally, the greater revenue generated and the desire to keep tenants in properties (as they are required to sell contracts) could result in improved quality of public housing and longer tenures. Finally, from a government perspective, this is a cheaper intervention to achieve a desired result relative to existing mechanisms.
A moderately interesting idea that has been on my mind.
Have renewable energy producer. Purchasers of renewable energy pay a pre-determined price per month; much like a mobile phone plan. The payments are then packaged and sold to investors. Thus investors will receive the value of the contract at a pre-determined time while the energy producers will receive the present value of the contracts. These contracts can then be traded a market.
Owners of these renewable energy contracts can also write derivatives such as options to earn extra income. These options can then be traded in a derivatives market. Trading derivatives will incur a fee and a portion of these fees will be returned to the renewable energy producer. Thus if derivatives are traded frequently, the renewable energy producer may make more revenue per unit of renewable energy produced than if they were to generate revenue in a more conventional manner.
Parties involved:
Banks - would be involved in selling the initial renewable energy contracts and writing and trading the derivatives. One obvious issues from their point of view would be losing revenue from derivative trading transaction fees. To reclaim this revenue, in order to enter the derivative trading market, firms would have to deposit a pre-determined amount of money in the bank which the bank can use to receive interest. In addition, the bank could receive the transaction fees and give the interest they gain from making loans to the renewable energy producers. The requirement for firms wanting to get involved in the derivative market depositing money in the bank creates a stream of revenue which in addition to the transaction fees can be divided between the bank and the renewable energy producer.
Risk taking funds - would have access to environmentally friendly and less risky financial products. The renewable energy contracts would be less risky asset for the return they would provide as initially, the probability of the energy producer being able to make their debt payments is low however as more contracts are traded and more derivatives are traded, this increases the probability that the debts will be paid thus increasing the price of the contract. In addition, this would result in specific derivatives becoming more attractive investments which in turn will result in the contracts becoming less risky which then influencing derivatives prices and so on.
Safer funds eg mutual funds - would provide capital for other more risky funds/investors to have access to the market and would share in their profits if any are made.
Renewable energy producers - would receive an upfront payment when the right to receive a consumers fee is sold and would receive a continuing stream of income based on the sale of derivatives based on the initial contract they sold.
Society - better off because renewable energy may become more financially attractive to firms and thus increase its production. In addition, changing the electricity fee structure results in eliminating electricity price volatility.
How to encourage derivative trading:
Specifically, how to encourage option trading.
For this mechanism to work, a high volume of derivative trading is required. This can be achieved using two mechanism both of which are based on the relationship between the percentage cost of an option relative to price of the underlying asset versus the risk free interest rate.
cost of option/underlying asset = interest/principal
If the cost of option/underlying asset is equal or less than interest/principal, then an investor, instead of purchasing the underlying asset should deposit the principal then receive the interest then purchase the option as the upside potential is identical while the downside potential has been eradicate.
If the cost of option/underlying asset is greater than interest/principal, then an investor should deposit money and receive the interest and provide insurance for the option writer at a small cost. Providing insurance for the option writer (after the option has been written) may lead to an increase in the writing of options as a writer will receive a guaranteed return if they can get insurance. An increase in the number of options being written would lead to an increase in supply which would decrease the price of options. Once the price has decreased such that the cost of option/underlying asset is less than interest/principal, the investor can then purchase the options with their interest thus providing themselves with security of the insurance they agreed to provide. Doing so should allow the investor to pocket the fee they charge for the insurance.
Both of these strategies should increase the trade volume of derivatives which would result in either the renewable energy producer, the bank or both receiving healthy amounts of revenue.
Why:
Banks - make money and offer environmentally friendly financial products.
Funds - are able to invest in environmentally friendly products
Renewable energy producers - potential to make greater revenue without increasing output
The perfect hedge/the everlasting arbitrage
This hedge involves deposits, interest and options.
The basic mathematics that determines one’s decision making process involves the relationship between the interest one receives from a fixed asset; for example depositing money in a bank or receiving interest from a bon and the percentage cost of an option relative to the underlying stock.
i = interest
p = principal
CoO = cost of option
SP = share price
i/p = CoO/SP
Scenario 1
i/p > CoO/SP
If the interest one receives is greater than the cost of an option for an option in which the share price and principal are equal then one should deposit the principal, then receive the interest and purchase the option. This would result in greater upside returns relative to purchasing the share and eradicate all the downside risk.
Scenario 2
i/p = CoO/SP
If the interest one receives is equal to the cost of an option for an option in which the share price and principal are equal then one should deposit the principal, then receive the interest and purchase the option. This would result in identical upside returns to purchasing the share and eradicate all the downside risk.
The above two scenarios would result in increased demand for options which would increase the price of options eventually pushing the price above the interest one would receive.
Scenario 3
i/p < CoO/SP
If the interest one receives is less than the cost of an option for an option in which the share price and principal are equal then one should deposit the principal, the offer insurance to option writers. Offering insurance would involve paying the option writer if they experienced an adverse price movement. The cost of insurance would be equal to the difference between the cost of the option and the interest you are receiving. Providing insurance should result in an increase in the supply of option contracts which should drive down the price of option contracts to a point in which they are below the interest rate one is receiving. Once they reach this point (or at any point in which they are less than the sum of interest and fee received for insurance), one can purchase the option thus closing their position and pocketing the difference between the interest and fee received and the cost of the option. Thus the lower the option price the greater the profit. In addition, the lower the option price the more leverage comes into play which can increase one’s earnings. The only way to lose money is if the option price rises after you have sold insurance, however this seems unlikely as providing insurance results in an increase in the risk free return thus safe investors should just write contracts and get insurance for the high risk free interest rate. This would increase supply and drive down prices. If prices are driven down enough the one enters scenario 2 or 1 in which a risk free opportunity to make money arises.
Modified call-put strategy
Aim - to minimise downside risk while maximising upside return.
The idea is centred around call-put parity and aims to provide risk free return from a premium received for providing insurance to option writers.
Call-put parity
Stock + put option (at given strike price) = call option (at given strike price) + bond (worth strike price at expiration)
Future price + put price = call + strike
A call option writer is exposed to losses when the price of the underlying security increases. To mitigate this risk, one can provide insurance. That is, sell a contract in which the insurer would cover losses were the price to increase in exchange for a premium. Provision of insurance contracts should result in an increase in supply of options (call options in this example) due to the higher return relative to risk free security as both securities would pose the same risk. This should result in a decrease in the price of call options. Increased call option supply would result in a disequilibrium in the call-put parity (stock + put > call + bond). For equilibrium to be reached, the sum of the stock and the put must fall. As stock price and put price are inversely related, the stock price will fall while put price will rise. As the stock price falls, the probability that the option writer will make a loss decreases as does the probability that the insurance provider will have to make insurance payments. Thus the premiums that the option writer and insurance provider have received are low risk however higher than the risk free rate of return.
Example:
Share price = $50, Call = $1.50, Put = $0.5, present value of SP = 49
Assume a share is trading at $50 and a call option is written with a strike price of $50 and is on the market for $1.50. The option writer will write the option, sell it to the option buyer and receive $1.50. To mitigate their risk, they will purchase insurance from the insurance provider paying $0.50. Thus guaranteeing profit of $1.00. The insurance provider will sell insurance to other option writer of the same stock thus increasing supply of call options. The increased supply of call options should result in a decrease in price of call option which should then based on the call put parity cause a decline in the share price and a rise in the put price. The final outcome would be a share price below the initial price. This would result in the insurance provider not needing to make any insurance payment.
Initial Call put parity:
50 + 0.5 = 1.50 + 49
After insurance provision:
49 + 1 = 1 + 49