Investors in the current economic climate, where interest rates are at historical lows, are in the search for “yield”. The perception is that equities provide a higher return than returns from fixed income and cash investments.

No doubt investors, in these circumstances, are cognisant of the market risks associated with movements in the price of such equity investments, which can (in the worst case scenarios) cause catastrophic financial consequences.

At the outset, this article attempts to define an equity investment in ASX-listed securities before then considering the nature and type of equivalents to an equity investment.

The US investment manager, BlackRock, defines equity investments as follows:“An equity investment is money that is invested in a company by purchasing shares of that company in the stock market. These shares are typically traded on a stock exchange.”

The beauty of this definition is in its simplicity and in the ability of the reader to understand the basic concepts in that an exchange takes place: cash is paid by the investor in exchange for shares in a company (where such shares are traded on an approved and regulated securities exchange).

An “equity-equivalent” can be best described as an investment that best mirrors an investment in an equity investment. Therefore, investments, such as convertible notes/bonds or hybrid securities are not appropriate to be considered as equity-equivalents as there is no certainty that the investment will ever be converted into equity, or even mimic movements in the underlying equity, throughout the duration of the investment in the equity-equivalent.

Understanding LEPO (futures) contracts

A futures contract can be opened using what is referred to as a “low exercise price option” (LEPO) on the ASX. A LEPO is a European-style call option with an exercise price of one cent. Both buyer and seller operate on margin. Because it is almost a certainty that the holder will exercise the option at maturity, it is very similar to a futures contract.

A European-style instrument (in contradistinction to an American-style instrument) denotes that holder of the instrument can only exercise their rights at expiration. Whereas the holder of an American-style instrument denotes that the holder of the instrument can exercise their rights at any time before and at expiration.

Since LEPOs are essentially a very deep-in-the-money European-style call option, they have a very high delta value5 and trade similarly to the underlying stock. Because these options are of the European style, meaning they are only able to be exercised at expiration, their near-zero strike price almost guarantees that the holder will take delivery of shares at that time. The advantage over owning the underlying security outright is the participation in the performance of the underlying without any financial or legal issues caused by the direct holding of the underlying security.

Deep-in-the-money options have very high premiums, or initial costs. However, the investor holds LEPOs on margin, resulting in a lower upfront cost. Again, the benefits must be weighed against the disadvantages of having no claim on franking credits or the ability to vote the shares or the ability to loan out the securities.

Option contracts

There are a plethora of option contracts. There are many styles and various exotic natures. This article focuses on options contracts that can be opened and closed on the ASX and can therefore be exchange traded. These are “plain vanilla” call and put options over ASX-listed securities. A call option gives the holder the right to “acquire” the underlying securities, and the writer of the call option has the obligation to “sell” the underlying securities. Likewise, a put option gives the holder the right to “sell” the underlying securities and the writer the obligation to “acquire” the underlying securities.

For a position, in an option contract, to be equivalent to an equity position, the delta risk of that option contract must be +1. Call option delta behaviour depends on whether the option is “in-the-money” (currently profitable), “at-the-money” (its strike price currently equals the underlying stock’s price) or “out-of-the-money” (not currently profitable). In-the-money call options get closer to +1 as their expiration approaches. At-the-money call options typically have a delta of +0.5, and the delta of out-of-the-money call options approaches 0 as expiration nears. The deeper in-the-money the call option, the closer the delta will be to +1, and the more the option will behave like the underlying security.

The reader should be able to immediately discern that merely holding a call option does not perfectly mimic a long position in the underlying security, unless the delta risk is +1. To replicate a position in the underlying with a delta risk of +1, the investor must consider a call/put parity position.

What is a call/put parity position? In simple terms, a call/put parity is a principle that defines the relationship between the price of European-style call options and European-style put options of the same class, that is, with the same underlying asset, strike price and expiration date. Call/put parity states that simultaneously holding a long European call and short European put of the same class will deliver the same return as holding one forward contract on the same underlying asset, with the same expiration, and a forward price equal to the option’s strike price. If the prices of the put and call options diverge so that this relationship does not hold, an arbitrage opportunity exists, meaning that sophisticated traders can theoretically earn a risk-free profit. Such opportunities are uncommon and short lived in liquid markets.

From an income tax perspective, the investor pays and receives a premium for opening a long and short option position with the intention of acquiring the underlying, as a capital asset. If assigned or exercised, the net premium will form part of the cost base of the underlying asset. The event of an exercise or an assignment will have no tax effect.

In summary, the first element of the cost base and reduced cost base for the shares or units acquired by an investor via the use of options is:

• the amount paid to exercise the rights or options (except to the extent that the amount is represented in the cost base of the rights or options at the time of exercise), which is nil in the above example, plus
• the cost base of the rights or options at the time the investor exercised them, plus
• any amount that was included in the investor’s assessable income as aresult of the investor exercising his/her rights or options on or after 1 July 2001 (which is not applicable in this example

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By Richard Bobb F FIN

Being the founder and a former partner of Richard A. Bobb Chartered Accountants since 1982, Richard possesses over 35 years of experience in the accounting profession, providing a variety of domestic and international taxation consultancy and advisory work.

He was the former chairman and member of the Joint Legislation Review Committee of Chartered Accountants Australia & New Zealand (previously Institute of Chartered Accountants in Australia) (CAANZ) and CPA Australia as well as being the former chairman and member of the Legislation Review Board (a subsidiary entity of the Australian Accounting Research Foundation).  Richard also holds concurrent fellow memberships of the Taxation Institute of Australia and Hong Kong, is a fellow member of Institute of Chartered Accountants in Australia and a Fellow of Financial Services Institute of Australasia.

He has contributed extensively to professional journals such as the Butterworths Loose Leaf Taxation Service, NSW Law Society Journal, CAANZ Journal “Charter”, Taxation in Australia Journal, Hong Kong Taxation Institute Bulletin and has been a regular speaker at seminars in Hong Kong for the Hong Kong Society of Accountants, HK ICAA (Hong Kong Group) and the Taxation Institute of Hong Kong.