Jim Dull, CFA Financial Advisor

1. Concentrated Position Risk Management Tuesday, April 18, 2006 University of Colorado at BoulderFinance 4040 – Derivatives Jim Dull, CFA Financial Advisor Jeremy Shevlin, CFP Financial Advisor

2. Table of Contents • Introduction to Crestone Capital Advisors LLC • Concentrated Position Risk Management • Zero-Premium Collar Example • Variable Pre-Paid Forward Example • OTC vs. Exchange-Traded Options • Hedging Constraints • Derivatives Exchanges • Question & Answer Session

3. 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. I. Introduction to Crestone Capital Advisors LLC

4. II. Concentrated Position Risk Management • Preserve / protect wealth • Provide liquidity for diversification • Limit equity risk exposure • Defer capital gains taxes Reasons to Hedge:

5. II. Concentrated Position Risk Management (cont’d) Benefits Considerations

6. 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

7. III. Zero-Premium Collar Example (cont’d) ABC, Inc. – 5 Year Price Chart A B

8. III. Zero-Premium Collar Example (cont’d) In 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. A Short Call Long Put Upside Capped Investor does not participate in upside stock price appreciation above $30. Upside Participation Investor retains 100% of upside stock price appreciation less premium paid. At maturity, if the final price of ABC stock is $30 or lower, the call expires without value. Call Strike = $30 Investor retains first $5 of stock price appreciation. Initial Price = $25 Investor exposed to first $5 of stock price depreciation. of ABC stock Downside Exposed Investor has no downside protection other than premium received. Put Strike = $20 At maturity, if the final price of ABC stock is $20 or higher, the put expires without value. Downside Protected Investor has downside protection at $20 and below.

9. III. Zero-Premium Collar Example (cont’d) Zero-Premium Collar Upside Capped Investor does not participate in upside stock price appreciation above $30. Call Strike = $30 Investor retains first $5 of stock price appreciation… 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. Initial Price = $25 of ABC stock And is exposed to first $5 of stock price depreciation. And is exposed to first $(y-x) of depreciation. Put Strike = $20 Downside Protected Investor has downside protection at $20 and below.

10. III. Zero-Premium Collar Example (cont’d) ABC, Inc. – 5 Year Price Chart A B

11. III. Zero-Premium Collar Example (cont’d) 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. B Put Sale Intrinsic value = $10.00 Time Value = $0.00 Total Gain on Hedge: 1,000 contracts x $9.95/contract x 100 multiplier = Call Buy Intrinsic value = $0.00 Time Value = $0.05 $995,000 * Note that the investor retained his long stock position but incurred an unrealized loss of $1,500,000

12. 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

13. IV. Variable Pre-Paid Forward Example (cont’d) 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). Trade Date Maturity Three Years Upper Strike = $30 Investor retains up to $5 of appreciation Lower Strike = $25 Investor is fully protected below $25, less implied financing costs Advance = $21 (Investor receives $2.1M upfront)

14. IV. Variable Pre-Paid Forward Example (cont’d) ABC, Inc. – 5 Year Price Chart A B

15. 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.

16. 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 V. OTC vs. Exchange-Traded Options

17. Regulatory Rule 144 Section 16(b) Margin requirements Trading windows VI. Hedging Constraints Practical/Operational • Liquidity • Marginability of shares • Float (borrow) • Behavioral constraints

18. 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) VII. Derivatives Exchanges

19. VIII. Question & Answer Session