|By Drucker, Vanessa|
Corporate users of equity derivatives continue to seek out simple, transparent products. Until regulatory overhaul is complete, this tack is unlikely to change.
The ripples from the 2008 financial crisis continue to flow, even into equity derivatives. Since
Vanilla is still the flavor of choice and 'keep it simple,' the overriding theme. Historically, most corporations have eschewed more exotic, custom-made instruments. "Corporations tend to have less-sophisticated treasury departments than institutional investors," explains
What differentiates providers now, as a result, is size. Bank clients are more concerned with very large notional amounts, which may run up to
Five years ago, when liquidity was more ample, even smaller banks and hedge funds could manage large positions. Once the global financial crisis hit, clients needed to implement huge yet simple hedging strategies, but only a few banks would enter big contracts in such volatile markets. Even today, liquidity in the options market remains scarce for some companies.
Aside from standard puts and calls, companies are also using asset swaps, forward sales, swaptions and infinite or "structured" repos that allow the holder to retain ownership. Because many of these over-the-counter instruments are specifically customized, "it may be hard to describe the exact structure or guess the volume," says Vinella.
Yet some of the basic products remain popular. For instance, even during a dearth of M&A activity, companies use options for quietly obtaining a foothold position in potential takeover targets. Thus, they can fly below the radar and avoid publicly reporting stakes, as only equity stakes above a certain level must be registered with regulators – for example over 5% in the US.
Another strategy sometimes used to raise cash is for companies to write put options on their own stock if they believe it is underpriced. If the stock price falls and options are exercised, firms can buy back shares even more cheaply. But there are not many natural sellers of puts, points out
Since the dotcom era, corporate executives have been using asset swaps to exchange their personal bonus shares – getting the economic value of the equity for the price of a small premium.These are more prevalent than ever, according to Vinella. Nowadays, however, corporations rather than just individuals are similarly engaged, and at better rates. Since the recession, companies have bought back stock, building substantial treasury positions. From their large pools they might exchange some treasury holdings for, say, die equivalent value of US Treasury bonds, paying perhaps
In other areas, interest in index products has also picked up. Volatility index tracking instruments (VlX) have been embraced widely.
New regulations are also moving firms toward index options – for example insurers preparing for the EU's Solvency II insurance overhaul. It will require insurers to increase their capital buffers. "Insurance companies are using index options to hedge their large industrial porrfolios.They can't sell them quickly, and the new rules penalize those investments," says Buttier.
Regulatory transparency is, of course, the other major driver affecting derivatives' use. As cross- border transactions grow, it is challenging to grasp worldwide ramifications for derivative regulations. Clients are demanding turnkey advisory services to cover legal and accounting implications. Corporations are therefore looking beyond die performance payoffs, says Buttier. "They want to know the regulatory impact from day one."
Meantime, in both
"The issue of whether to let corporate end users off the hook is still pending. Until it's settled, they can't plan ahead"
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