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Jim Dull, CFA

Financial Advisor

Jeremy Shevlin, CFP

Financial Advisor

Concentrated Position Risk Management

University of Colorado at Boulder Finance 4040 – Derivatives

Tuesday, April 18, 2006

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Table of Contents

I. Introduction to Crestone Capital Advisors LLC

II. Concentrated Position Risk Management

III. Zero-Premium Collar Example

IV. Variable Pre-Paid Forward Example

V. OTC vs. Exchange-Traded Options

VI. Hedging Constraints

VII. Derivatives Exchanges

VIII. Question & Answer Session

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I. Introduction to Crestone Capital Advisors LLC

• Crestone Capital Advisors LLC (“Crestone”), based in Boulder, Colorado, is an independent wealth management firm for high net worth individuals, families, and foundations.

• Our services include investment management, concentrated position risk management, estate and philanthropic planning, and income tax planning and reporting.

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II. Concentrated Position Risk Management

• Preserve / protect wealth

• Provide liquidity for diversification

• Limit equity risk exposure

• Defer capital gains taxes

Reasons to Hedge:

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II. Concentrated Position Risk Management (cont’d)

Ben

efit

sC

on

sid

erat

ion

s

Sale of Position Short vs. Box Sell Calls Buy Puts Collar Pre-paid Forward

Generates Eliminates Generates No Ceiling on Can be Zero Significant Cash Flow Downside Risk Cash Flow Upside Exposure Cost Liquidity Generated

Eliminates No Tax Event No Tax Event No Tax Event No Tax Event No Tax Event Downside Risk (Until Earlier of Until Maturity Until Maturity Until Maturity Until Maturity

Short Cover or 1/31Next Calendar Year) Provides Floor Provides Floor Provides Floor

on Stock Price on Stock Price on Stock PriceCan Generate Cash Flow Via Margin Loan (up to 95%)

Recognizes Eliminates Upside Creates a Ceiling on Potentially Ceiling on Ceiling on Capital Gain Opportunity Upside Opportunity Significant Up-front Upside Opportunity Upside Opportunity

(Until Call Expires) CostEliminates UpsideOpportunity

Monetize Puts Monetize Collar

Protected Stock Position Facilitates

Collateralized Lending Arrangement

Concentrated Equity Position

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III. Zero-Premium Collar Example

Zero-Premium Collar Description

• Most common exchange-traded hedging/ monetization transaction

• Standardized contracts

• American-style options

• Tax deferral strategy

• Creates downside floor and allows for upside participation

• Possible up-front liquidity via margin loan

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III. Zero-Premium Collar Example (cont’d)

ABC, Inc. – 5 Year Price Chart

A

B

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III. Zero-Premium Collar Example (cont’d)

Call Strike = $30

Initial Price = $25

Upside Capped

Investor does not participate in upside stock price appreciation above $30.

Downside Exposed

Investor has no downside protection other than premium received.

At maturity, if the final price of ABC stock is $30 or lower, the call expires without value.

Long PutShort Call

Investor retains first $5 of stock price appreciation.

AIn early 2002, an investor that owns 100,000 shares of ABC stock executes 1,000 Jan 2003 $20 put, $30 call collars for even money (covering all 100,000 ABC shares) when ABC stock is trading for $25/share.

Upside Participation

Investor retains 100% of upside stock price appreciation less premium paid.

Downside Protected

Investor has downside protection at $20 and below.

Investor exposed to first $5 of stock price depreciation.

Put Strike = $20At maturity, if the final price of ABC stock is $20 or higher, the put expires without value.

of ABC stock

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Upside Capped

Investor does not participate in upside stock price appreciation above $30.

Downside Protected

Investor has downside protection at $20 and below.

Call Strike = $30

Initial Price = $25

Put Strike = $20

At maturity, if the final price of ABC stock is at or between $20 and $30, both the call and put options expire without value.

Investor retains first $5 of stock price appreciation…

And is exposed to first $(y-x) of depreciation.

III. Zero-Premium Collar Example (cont’d)

And is exposed to first $5 of stock price depreciation.

Zero-Premium Collar

of ABC stock

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III. Zero-Premium Collar Example (cont’d)

ABC, Inc. – 5 Year Price Chart

A

B

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III. Zero-Premium Collar Example (cont’d)

B In September 2002, the same investor exits 1,000 Jan 2003 $20 put, $30 call collars for $10 per contract (covering 100,000 ABC shares) when ABC stock is trading for $10/share and retains his 100,000 long ABC shares.

Put Sale

Intrinsic value = $10.00 Time Value = $0.00

Call Buy

Intrinsic value = $0.00 Time Value = $0.05

Total Gain on Hedge:

$995,000

* Note that the investor retained his long stock position but incurred an unrealized loss of $1,500,000

1,000 contracts x $9.95/contract x 100 multiplier

=

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IV. Variable Pre-Paid Forward Example

Variable Pre-Paid Forward Description

• Most common OTC hedging/monetization transaction

• Fully customizable contracts

• Most likely European-style options

• Tax deferral strategy

• Creates downside floor and allows for upside participation

• Significant up-front liquidity inherent in structure

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IV. Variable Pre-Paid Forward Example (cont’d)

Upper Strike = $30

Lower Strike = $25

Advance = $21

MaturityTrade Date

Three Years

Investor retains up to $5 of appreciation

In early 2002, an investor that owns 100,000 shares of ABC stock enters into a 3 year VPF contract when ABC stock is trading for $25/share.

The VPF is structured with a minimum price/share value of 100% ($25/share), maximum price/share value of 120% ($30/share), and a cash advance of 84% ($21/share).

Investor is fully protected below $25, less implied financing costs

(Investor receives $2.1M upfront)

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IV. Variable Pre-Paid Forward Example (cont’d)

ABC, Inc. – 5 Year Price Chart

A

B

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IV. Variable Pre-Paid Forward Example (cont’d)

In early 2005, the price of ABC is $12 and the investor settles the trade

by delivering 100,000 shares of ABC stock to the counterparty.

Had the investor remained un-hedged over the 3 year period and held

the long position, she would have lost the benefit of investing the

$2.1M cash advance and would now only have $1.2M worth of ABC

stock.

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V. OTC vs. Exchange-Traded Options

OTC• Customized• Counterparty risk• More expensive• Largely unregulated• Privately negotiated• Less liquid

Exchange-Traded• Standardized• No counterparty risk• Less expensive• Regulated• Publicly traded• More liquid

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VI. Hedging Constraints

Regulatory• Rule 144• Section 16(b)• Margin requirements• Trading windows

Practical/Operational• Liquidity• Marginability of shares• Float (borrow)• Behavioral constraints

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VII. Derivatives Exchanges

Futures Exchanges:• Chicago Mercantile Exchange

(CME)• Chicago Board of Trade (CBOT)• New York Mercantile Exchange

(NYMEX)

Equity Option Exchanges:• Chicago Board Options

Exchange (CBOE)• American Stock and Options

Exchange (AMEX)• Philadelphia Stock Exchange

(PHLX)• Boston Options Exchange

(BOX)• International Securities

Exchange (ISE)

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VIII. Question & Answer Session