Banks are benefiting from an increase in corporate sector demand for alternative ways of raising finance while capital markets are effectively closed.
Recent announcements by the US-based International Swaps and Derivatives Association (Isda) on outstanding over-the-counter derivatives contracts dwelt on the explosive growth in credit derivatives volumes: 100% a year since 1996 versus the more pedestrian 26% annualised increase in equity derivatives, with $1900bn of outstanding contracts. Yet the bare statistics mask an important shift in market share towards a growing use of equity derivatives by the corporate sector at the expense of the investor segment.
This shift marks the coincidence of two processes: the sophistication of corporate treasurers and chief financial officers; and the effective closure of traditional capital markets, which has forced them to consider alternative financing tools.
Back-up tool
A recent addition to the risk management toolkit alongside credit derivatives, OTC equity derivatives can act as a back-up if a capital markets solution can not be achieved. Corporates' desire to deleverage and clear the balance sheet of unpopular cross-shareholdings without indulging in a fire-sale or a rights issue means they are willing to look at other ways of monetising assets. The final act in the drama will often be a traditional capital markets transaction, when the timing is more auspicious. And, although Enron-like structures involving opaque accounting and off-balance-sheet vehicles are understandably less prevalent, the spotlight thrown on these techniques has spurred a quantum leap in treasurers' knowledge of financial engineering.
Equity derivatives are now an integral part of the equity dialogue between banks and corporates. Reflecting this change, almost all the major banks have restructured to accommodate equity derivative specialists in their equity capital markets (ECM) function. This avoids separate teams accessing the same company offering competing products.
The ECM function has acted as gatekeeper to corporate clients and conflicts over access were widespread. Since the largest transactions involve equity derivatives (for which contracts are struck solely between the bank and the corporate client), and are equity linked (where a company will issue securities in the market that convert or exchange into shares), and a cash equity placing, it seems natural to offer products in parallel. Some products are close analogies, for example the exchangeable versus the written call. And, if the ultimate solution is a public market transaction, derivatives skills are not enough.
UBS Warburg, JP Morgan, Morgan Stanley and Goldman Sachs have completed initiatives to move corporate equity derivatives marketing under the ECM umbrella.
The large size and stock-specific risk of corporate transactions create complex risk management problems. The ability to 'warehouse' risk until both stock and volatility risk can be hedged is of key importance. About 75% of transactions are equity swaps or narrow collars, the pay-off profile of which is similar to a straight sale of stock.
An equity swap involves the company paying out the positive returns on stock held and receiving the negative returns, while receiving a sub-London interbank offered rate (Libor) financing fee. This arrangement effectively neutralises the stock exposure and monetises changes in the asset price from the price at which the swap is struck.
A narrow collar involves the sale of a call and the purchase of a put, with strikes that are close to each other. So there is a fairly narrow range of stock prices within which neither the call nor the put will be in profit on expiry. If the call is in-the-money, the company may deliver the stock or pay out the difference in cash between the settlement price and the strike price. If the put is in-the-money, the company may place the stock on the purchaser of the put or receive the difference in cash between settlement price and put strike.
Buying volatility
Trades such as these, with a delta of one, can be larger than those involving optionality because they are easier to hedge. Trades that leave the bank long or short options are more problematic because the market in volatility is smaller. In most cases, the bank will be buying premium, which it can either distribute to institutional and retail clients, in the form of synthetic convertibles or warrants, or build up an inventory if the price is deemed low enough. At current levels, most banks appear to be comfortable buying this volatility to hold on the books because levels of implied volatility in the market are at their lowest for two years.
When buying downside risk on a stock from the company, banks need to be aware of the correlation between the company's share price and its credit standing. "A swap or a purchase of puts on a company's stock could be an embedded credit exposure because the company's ability to pay its obligations under the contract might diminish as the stock price falls," says Mark Colman, executive director at Morgan Stanley in London.
Corporate clients' biggest dilemma is in selecting a counterparty for these deals. The size and sensitivity means that obtaining an array of competitive quotes is a non-starter. Arnaud Apffel, ECM managing director at Goldman Sachs, likens interacting with the market on these deals to taking the temperature of a fridge. "The more you open the door, the greater the increase in temperature," he says. "Corporate deals in Europe are typically for a notional amount of E100m or more, although most banks are targeting the most lucrative E1bn-plus bracket."
Corporates that have shown business too freely have seen the levels of implied volatility in their stock fall from 25% to 15% in a day. "To achieve a price improvement of 0.5% to 1% in volatility, it is simply not worth it," Mr Apffel says.
Choosing a bank
For the biggest deals, rather than discussing trade specifics, a company must pre-select a bank based on the quality of its ideas, an understanding of what affects pricing and how the bank will hedge the trade. Corporate treasurers are increasingly aware of options market pricing. Mr Colman says: "Clients regularly ask where the listed options in their stocks are trading and seem to understand that their stock's volatility is a valuable commodity."
The lead time from initial call to deal can be around six months and, to ensure trading books are not compromised for extended periods, traders are brought in towards the close of a deal to confirm pricings. Indicative levels using market parameters are supplied by ECM financiers until that point.
Mr Apffel estimates about 50% of deals are done as block trades, as opposed to worked orders, whereby the dealing price is linked to the price at which the bank hedges the stock. It is crucial to have an appetite for large size and an ability to take the risk on to the books and manage it. For example, Goldman Sachs has dealt on 7% of the issued share capital of a French stock.
Key strategies in cross-holdings management are monetisation, financing or hedging, and yield enhancement. Stakeholders can extract value from the stock's volatility by writing premium - Mr Apffel says call writing is still the "best seller". An estimate of future volatility is a key determinant in options pricing: the higher the expected volatility, the more expensive the option. Other features may be added to take advantage of skew (variation in implied volatility with option strike) and the term structure of volatility (variation in implied volatility with option expiry).
Banks and insurers in France, Germany and Italy are the biggest clients for this strategy, although the most sophisticated are Swiss corporates, which now rarely transact plain vanilla structures.
Once a stake is protected by a forward sale or swap, banks will be prepared to lend money against it, creating a derivatives structure that is analogous to a mandatory exchangeable. Here the corporate is monetising the entire stake, or a portion of it, rather than just the volatility. Even though these transactions can result in the effective economic sale of a holding (because the bank may be prepared to lend 100% of the value of the protected stock), there is no market disclosure requirement as long as the stake continues to be held beneficially by the company.
German examples
Before capital gains tax on sales of cross-holdings was removed in Germany in January 2002, a number of forward sales of stock were transacted, with expiries set for beyond the effective date of the change. Possibly the first of these transactions was the E2.5bn short sale of Allianz stock by Deutsche Bank in July 2000, as part of a complex swap arrangement with a third party acting on behalf of its investment company DB Investor. Many market participants at the time regarded the transaction as a way for Deutsche Bank to display publicly its expertise in this market and the German banks have probably seen the lion's share of business from their compatriots.
Where international banks were involved, the deals have been transacted under German documentation rather than the more usual Isda agreements. This window of opportunity was somewhat clouded by poor equity markets, however, and recent speculation about a re-imposition of this tax could be interpreted as government encouragement to do something.
Vivendi swap deal
Possibly the largest trade of this type was the E4.2bn swap and financing of BSkyB stock by Vivendi, executed in the fourth quarter of last year. This monetisation fulfilled Vivendi's commitment to divest made after it took over Universal Studios. Vivendi swapped the returns on the BSkyB share price and was able to raise E4.2bn to repay other debt and finance share buy-backs.
Some have described this transaction as a disguised loan to Vivendi, which is treated as an off-balance sheet contingent liability through the use of a special purpose vehicle. Mr Colman says: "This type of transaction, post-Enron, is not in favour and the focus is now on pure economics over accounting presentation."
Another form of yield enhancement that banks with excess tax capacity offer is the transfer of beneficial ownership over the dividend payment to an entity operating in the domestic markets. The bank then passes through some of the tax credits that are normally only available to domestic investors. One bank admitted to transacting these types of deals, saying they were structured in such a way that they were justifiable on other grounds.
Share buy-backs
One area of business that is not increasing despite significantly lower equity prices is share buy-backs. In the late 1990s, US technology stocks were aggressive buyers of their own shares through straight sales of puts and collars. However, leveraging by reducing the capital base does not make sense when profits are falling and companies have less free cash flow.
With volatility and share prices depressed, corporates are mainly hedging and reducing share price volatility more than actively buying back stock. Accounting rule changes have also made this business much more transparent.
The jumbo E3bn France Telecom convertible issue last year was made possible because the company held Treasury stock earmarked for delivery if the bonds were converted. This made the issue effectively an exchangeable on its own stock.
Convertible or exchangeable deals can often be an opening for additional associated derivative transactions. One example is if a company does not want to dilute control over a strategic stake but wants to take advantage of favourable exchangeable pricing. It might offer an exchangeable and simultaneously write a collar on the stock to buy shares into a decline and replace any stock called away. A written collar is a transaction in which the company buys the call and sells the put, making it a buyer of stock below the put strike and above the call strike.
The deactivating swap, which was prevalent in 1997 and 1998 and became popular again in late-2001, allows corporates to swap the fixed coupon for a Libor-based interest payment and cancel the swap if the bond is ever converted (if the equity price rises above the call trigger price). A company that has issued an exchangeable and has seen the stock price subsequently fall might lock in its profit on the written call embedded in the bond by buying calls at the lower stock price. It is then free to sell out the underlying stock into any share price recovery, knowing that the shares deliverable under the bond are covered by the call option it has bought.
This convergence of convertible and equity derivatives markets has been facilitated by a reduction in the average term of a convertible from 5-7 years to 3-4 years, and by a greater appetite among traders for longer-dated single stock volatility.
An M&A tool
Equity derivatives are increasingly being used in merger and acquisition negotiations to secure stakes in secret, fine-tune financing options and manage arising exposures. Minority shareholders may be more inclined to accept a deal if some monetisation or hedging of any locked-up stock is on offer.
Contingent value rights (CVRs) have been offered to sweeten a deal, such as during France Telecom's takeover of internet service provider E-Quant. CVRs are effectively securitised put spreads that protect the holder of stock to a limited extent against adverse stock price movements. A put spread is the combination of a long put and a short put at a lower strike price, which protects the holder of stock against a fall in the stock price down to the lower strike.
The derivatives structures used in the context of a merger or acquisition are similar to those used in a share repurchase but the instances are less frequent. Sold puts, bought calls or written collars are transacted for cash or physical settlement at the buyer's discretion. Because these transactions can exercise into cash and not a real shareholding means they need not be disclosed until the company elects to turn them into a physical holding.
EDF, the French electricity company, gained a foothold in its purchase of a 20% stake in Italian agribusiness, chemical and energy group Montedison by purchasing a narrow collar on 3.14% of the company. Between the call and the put strike there is a small stock price range over which EDF has no stock exposure. The deal, announced in June 2001, was struck for expiry in September 2002 but it is understood that EDF will not in any event become a beneficial holder of any Montedison shares on expiry, a point required by the authorities.
JP Morgan Chase assisted in the December 2000 completion of Telecom Italia's purchase of Italian multimedia group Seat Pagine Gallia by effectively replacing a 7% minority shareholder and extending the expiry of a put that Telecom Italia had granted to that shareholder. Telecom Italia now has a put with JP Morgan and owns calls on most of the block.
More flexibility
According to Cristina Garcia-Peri, JP Morgan's head of corporate equity derivatives in Europe, JP Morgan showed Telecom Italia a way to keep the put liability off-balance sheet by substituting JP Morgan for the minority investor. "We will see more transactions of this type, as companies use equity derivatives to add flexibility to their decision-making on strategic stakes," says Ms Garcia-Peri. "Equity derivatives offer the opportunity to buy off balance sheet or synthetically, set prices for disposal now or later, and generally manage a strategic position."
Mr Apffel believes Italy will be a particularly promising market for the unwinding of cross-holdings, and thinks that encouraging chief finance officers to develop effective strategies for the management of stakes will become an important focus for investor activism.
"The market is gradually becoming aware of the potential of derivatives and will soon hold management accountable both for using derivatives in a speculative risk-increasing fashion and for not using them in situations where they can provide protection," he says. "Initially this is something that equity analysts will pick up on, and then the press, and ultimately the shareholders."
