The New Beat of Equity Derivatives
Long the Street's wallflowers, equity derivatives are capturing
the spotlight with an attractive combination of risk-mitigation and yield-enhancement
By Nilly Ostro
When equity derivatives burst on the scene earlier in the decade, proponents brashly predicted that they would immediately capture the imagination of
institutional equity investors and quickly rival the volume of fixed-income
and currency derivatives.
The bond boom-and-bust that has dominated most of the decade put equity
derivatives in something of a shadow, and most pension funds and money managers
were content to ride the rising stock markets without much help from derivatives
But now, half a decade later, equity derivatives dealers are finding
new demand from both the risk-averse and the yield-hungry. As the Dow does
its daily tango around the 7,000 mark, investors are flooding into equities,
pouring a record $29.4 billion into stock mutual funds in January alone.
Bond managers, meanwhile, took in a measly $2.9 billion, about half their
January 1996 inflow.
These figures are sweet music to the ears of equity derivatives marketers, who are enjoying the benefits of two separate trends. A "toppish"
stock market is giving prudish investors the quivers-and a taste for hedging.
At the same time, bond investors are eager to use converts and other derivatives
to get in on the equity game before it's too late.
The result is a trading boom and a structuring bonanza. Although the
basic building blocks have not changed much, new applications in both domestic
and international markets are proliferating.
Volume is coming from a variety of sources. Traditional equity investors looking to outperform their benchmark are locking in current returns by
giving up future upside. Nonequity investors, meanwhile, are adopting all
manner of yield-enhancement strategies to "equitize" their cash
without taking explicit equity positions. And companies in need of funds
and aware of the increasingly volatile cost of equity capital have been
using derivatives to manage the cost of future equity capital via long-term
options and all manner of mandatory conversion structures, like PERQs, ELKs
and DECs. "Investors' and issuers' awareness of risk and know-how of
financial theorems is moving from interest rate and currency to the equity
side," says Waite Rawls, principal at Farrell Capital Management.
Dealers say end-users now approach equities with a new-found strategy
and desire to manage exposure through the use of available tools. "There's
been a sea change in how equity investors look at derivatives," says
Jim Smith, vice president of equity derivatives at Goldman Sachs. Investors
no longer look at equity exposure as unmanageable and returns largely based
on chance. Rather, they define the sort of exposure they want to have and
then use the OTC or listed markets to create it and manage it over time.
"It's a fundamental and philosophical shift, and it's very different outlook on equity investing," he explains. "Before, when I went
to visit customers, I was met with a high degree of skepticism. Now, investors
are more likely to focus on whether or not the idea has merit." Adds
Sarah Orsay, vice president at DMG: "People are not apologizing anymore
for using derivatives. They've realized that they are not the evil instruments
they have been made out to be. The tone has really changed."
Volume on the options exchanges is rising steadily-and making the markets more efficient. In 1996, for example, average daily trading volume on the
CBOE surged close to 350,000. Total contract volume inched close to $90
million, up from $77 million the year before.
"Higher trading volumes are driving pricing closer to real value," says Jay Elkins, vice president of equity marketing at Bankers Trust. Elkins
equates the introduction of the S&P options to the launch of the additional
Eurodollar futures. Both have given the "middlemen" a transparent
hedging venue, infusing the entire market with liquidity. "Market efficiencies
have made equity derivatives a more attractive investment," he says.
And they are forecast to become more so. A recent study by Price Waterhouse and the Futures & Options Association in London reveals that the market
expects volumes to continue to surge. Thirty-six percent of the survey respondents,
which included broker/dealers, investment managers and corporate end-users,
said they anticipate a significant increase in the volume of equity derivatives.
"That is the highest percentage for any product," says Chris Taylor,
a partner at Price Waterhouse and the report's author. In fact, some experts
estimate equity derivatives are growing at four to five times the pace of
interest rate and currency products-albeit from a much smaller base.
Such rosy growth predictions reflect not only the market's current momentum, but also a fundamental shift in its composition. "If in the past the
market was 75 percent retail and 25 percent institutional, it's now 50-50,"
says Bill Brodsky, incoming chairman and CEO of the CBOE. The inflow of
institutional money has helped fuel the market's continued success. In addition,
individual stock market players have been using options for many conservative
The biggest action is on the international stage. Without question, international portfolio managers have taken to equity derivatives first and have quickly
make them integral parts of their management strategies. Domestic equity
managers who use derivatives are still in the minority, "and many of
those use derivatives mainly as a way to 'equitize' cash," says Joanne
Hill, vice president of equity derivatives research at Goldman Sachs. But
among funds that invest overseas, the proportion of derivatives users is
high. "There is significant growth in the number of pension funds,
foundations and money managers that have incorporated derivatives into their
international investment strategy."
It's not surprising. The utility of derivatives is more pronounced in
the international arena. Derivatives dealers have always pointed out how
their products allow international managers to take a position on an entire
market at a fraction of the cost. "With the typical equity swap, you
can capture 100 percent or more of the dividend yield," says Goldman's
Hill, compared with 85 percent with a direct investment.
The reason: most countries impose a 15 percent withholding tax on dividends. Goldman has found that the benefit of capturing that additional 15 percent
of dividends can be as much as 25 to 28 basis points per annum for investments
in Europe. In some countries that offer dividend tax credits, the yield
can be up to 150 percent of the dividend using derivatives versus the underlying.
Stamp fees, transaction costs, custodial fees and so on make stock investment overseas an expensive alternative even for investors who are allowed by
regulators to shift money outside their borders. In some countries, like
France or Germany, the cost advantage of owning a future vs. the underlying
may range from 50 to 100 basis points each year.
"We've seen a huge run-up in 199596 by pension funds toward
greater international exposure," says DMG's Orsay. The global push
began in the early 1990s, and has not abated despite the stellar performance
of the U.S. market. Orsay suggests that the dramatic rise in U.S. equities
has in fact exacerbated the trend. "The higher valuations have encouraged
people to re-balance through international diversification," says Orsay.
"Plus, since pension managers have earned significantly more than their
approximately 10 percent annual actuarial assumption for U.S. equities in
the past two years, they feel that they can afford to take on the additional
risk through foreign exposure. "There is more money to invest elsewhere,"
Mostly, it's been going into index-driven swap products. Typically, pension funds will take the equity returns of a foreign market in the form of a
swap, either to a standardized index like Morgan Stanley EAFA or a basket
designed to mimic their own internal benchmarks.
The swap construction is simple. The dealer agrees to pay the investors
the total return or price-only return of the basket/index for two or three
years. In return, investors pay the dealer a quarterly interest rate that
floats at a fixed spread over (or under) LIBOR. The dealer hedges its position
by buying either futures or the underlying stock. "Pension funds typically
'collateralize' these swaps with a highly liquid, highly rated cash pool
that generates a LIBOR-like return," says Orsay. Often, there's a currency
overlay on top of the equity swap. Some managers seek 100 percent protection
from FX moves, some 50 percent, while others want full currency exposure.
"That's the beauty of derivatives-the ability to customize the exposure
to the individual fund's investment objectives and risk tolerances fully,"
More sophisticated pension derivative users are now buying swaptions
on foreign index baskets. In this scenario, investors who believe today's
market is somewhat overvalued would sell to the dealer a put option on an
international index, for example. Investors determine the level at which
they are comfortable buying the market (that is, the put strike). If the
market depreciates to or below the level of the put strike, investors are
"put" into a swap in which they are long the market at the strike
level. The investor has generated up-front premium from the sale of the
put option. The risk in this strategy is that the market experiences a significant
correction beyond the level of the put strike and the fund is put into the
market at levels significantly above prevailing market levels.
The flip side is a swaption involving a call. In one popular structure,
investors sell, for example, a 95 percent three-month call on the Japanese
market to the bank. If during the three months the market is above 95 percent
of its current value, the option expires worthless and the client will have
generated some up-front premium. If it goes lower, say at 90 percent, the
client must buy the market at 95 percent.
"Japan continues to be a popular spot for equity derivatives application," says Goldman's Smith. Despite its lackluster performance, Japan remains
a large part of any international manager's allocation. At the same time,
it is becoming increasingly difficult to read. As a result, clients have
been opting for variations on principal-protective structures-which guarantee
the principal typically by buying a zero-coupon note (which matures at par)
and an OTC equity call option on the Japanese market. This structure establishes
a local market position with limited downside risk.
Bankers Trust's Elkins also reports keen interest in quanto options on
the Nikkei. The quantos are embedded into principal-protective notes and
combine an equity and currency play, guaranteeing a dollar-denominated Nikkei
return. The structure typically involves a currency forward that locks in
a future dollar/yen exchange rate. Investors get 100 percent of their principal
guaranteed, in dollars, plus some of the Nikkei upside.
It's important to note that although U.S. investors have been using derivatives to increase their international exposure, they have not done so at the expense
of U.S. equities. For instance, a once-popular strategy of paying S&P
in return for an international index has not been around recently. "Investors
may be bearish or at least nervous," says DMG's Orsay, "but few
seem willing to short the U.S. market directly right now."
This anxiety is reflected in the volatility numbers. "With the U.S. market at record levels, there's a great deal of uncertainty in the direction
of the market in the near future," says Satish Nandarpurkar, managing
director at DMG. "As a result, implied volatilities have soared."
Historically speaking, however, volatility remains rather low. This is
not surprising. "Equity volatility and the market are inversely related,"
says Gary Gastineau, senior VP and head of new product development at the
American Stock Exchange. But the "toppishness" of the market and
extremely high valuations are giving some investors pause. After two years
of rock-bottom volatilities, the new year has brought a definite upswing.
"With international markets at astronomically high levels, equity
investors are more nervous and looking at ways to hedge and reduce some
of their hedge premium cost through structured solutions," explains
Goldman's Smith. Such defensive strategies include structures that allow
investors to lock in current returns by giving up future upside as well
as buy-one/sell-one structures that place collars around the necks of some
high-flying tech stocks or entire market indices.
Other equity hedges with a cost-reduction feature include "Asian" options that pay an average payoff of an underlying, say the S&P 500.
The averaging aspect helps manage the exposure and allows dealers to lower
the cost of hedging by "roughly 40 percent," according to Smith.
For an outright defensive tack, some inventors have been turning to the
convertible bond markets (see story on page 52). More recently, convertible
investors have been facing a curious problem. Although 1996 was a record
year for new issues (a total of $31.5 billion in the United States alone),
a rising stock market has boosted net redemptions, leaving bonds in short
supply. "This has been frustrating for managers since it restrains
their portfolio size," says Mark Riepe, vice president at Ibbotson
Associates in Chicago. As a result, managers have begun to look more closely
at derivatives look-alikes.
"What's driving the demand is that many funds and plan sponsors
are using convertibles and convertible-like structures as a defensive way
of staying in the market," says John Calamos, who manages the $2 billion
Calamos convertible fund. While Calamos prefers traditional converts, he
uses derivatives either to access markets where there are no available issues
(such as high-tech) or where traditional converts are not trading at favorable
levels. Typically, he opts for synthetics that retain many of the features
of a traditional convertible. "We like five-year paper with a conversion
premium of about 20 percent and good call protection," he says.
The mandatory conversion variety, that is, PERQs, ELKs and so on, are
much less attractive. "PERQs and ELKs limit the upside but have very
little protection on the downside," says Calamos. "What we want
is limited loss, which is provided by the convert's bond value and unlimited
upside through the equity link." Calamos notes that demand for paper
has been so heavy that Wall Street has been doing little premarketing for
its structured issues. "We're seeing overnight issues," he says.
Although many market players harbor bearish fears, they are vastly outnumbered by the bulls. Hence yield-enhancement strategies are more prevalent than
"In the last two years, we've seen an increase in demand for long-term equity exposures," reports BT's Elkins. "Insurance companies used
to do OK just clipping coupons, buying MBSs taking a little-duration risk,"
he says. But with the stock market's spectacular performance, insurers have
a need to get in on the game.
The problem insurers face, however, is that they must put aside higher
reserves against equity investment. And that makes direct equity exposure
quite costly. One way for them to get equity returns without buying equity
is via protected equity notes. This basic variation on the principal-protected
structure involves an issuer who needs capital, a bank that puts together
a zero-coupon treasury bond and an equity call and an insurance company
that buys the end result. Since there is no principal risk, the insurance
company can treat this like debt and not be subjected to the higher capital
reserve requirements of equity.
Insurers have been using equity derivatives in another area-to enhance
the yield of the investment products they offer their own customers. The
rising popularity of IRAs, 401Ks and mutual fund investment is putting the
pressure on insurers to beef up their own product line. The result is equity-linked
annuities designed for investors who don't want principal risk, but do want
to be in the stock market. The annuities offer a minimum return plus an
upside play linked to the S&P 500.
A five-year annuity with an annual discrete structure may include up
to 80 percent of the equity's upside, with a minimum redemption value of
90 percent of the principal plus 3 percent accrual every year (as required
by law). The equity upside may be structured like a discrete look-back option
that is linked to the highest level the S&P reaches on any anniversary
of the option. "There's perhaps $1 billion in such annuities out there
today, up from $100 million a year ago," says BT's Elkins. He predicts
the market will double its size again this year.
Other yield-enhancement applications include yield-enhanced securities,
which combine a long position in stock and short position via an out-of-the-money
call on a different stock. The net effect is a capped upside-say up to 60
percent-in return for current income. The flip side of this play is a Goldman
product called ACES, an automatic convertible equity security. ACESs also
pay a high current dividend, but instead of giving up upside, investors
effectively sell options to Goldman that allow them to participate in the
upside only once the stock hits a certain level. "The investors are
economically long the stock and short a call-spread on the same stock,"
explains Smith. YESs and ACESs are normally structured for two- to three-year
In search of innovation
While they may sound complex, both defensive and aggressive derivatives
structures are by no means new. In fact, many seasoned players argue there's
been very little innovation in equity derivatives in terms of product design.
"I have been active in equity derivatives since 1981," says Jeff
Geller, executive director at BEA Associates. "And I see nothing terribly
revolutionary about these packaged products."
True, most later-day structures are combinations of basic building blocks that have been around since the 1980s. However, argues Goldman's Hill, they
are now being applied in novel ways in both the OTC and listed markets.
"Derivatives are raw materials that can be packaged in creative ways,"
she says. "It could be as simple as using futures and swaps in emerging
markets to get around settlement risk. The key is that we're seeing creative
In some cases, as in Nikkei quanto options, the result of innovative
thinking is a totally new product that straddles two markets. In other cases,
basic tools are employed to resolve complex problems. "One of our clients
was firing one group of international managers and hiring another,"
recalls Geller of BEA. The new management had a reputation for stock selection
but was not known for its market and currency management skills. BEA used
futures on market indices and currency forwards to rebalance country/currency
weights to be more in line with the client's benchmark. This, in effect,
isolates the stock-pricing skills, or the alpha, of the new managers. "Derivatives
offered a cost-effective way to leave clients exposed to the intended bets,
as opposed to the unintended bets, being taken by their managers,"
Goldman's Hill reports that a handful of traditional equity managers
have also begun to set up limited-participation "quasi" hedge
funds that use leverage to invest in LEAPs. "True, LEAPs have been
around for a while," says Hill. But their application in this setting
is novel. "Now, with limited leverage alongside a zero-coupon bond,
some of these funds are taking an equity risk that is greater than 100 percent
of principal," she says.
On the listed markets, the drive toward more tailored products will continue to produce new applications. At AMEX, the biggest news is the launch of
equity FLEX options. "We are anticipating very dramatic growth in this
product," says Gary Gastineau, AMEX's senior vice president and head
of new product development. At PHLX, sector indices give retail investors
a chance to play industries instead of stocks with a $75 investment.
Whether the stock market goes up or down, the future of equity derivatives appears better now than ever. The universe of potential equity derivatives
investors is now significantly wider. The trend toward the internationalization
of stock portfolios is likely to continue unabated. If stock prices drop,
they will likely ignite a surge in volatility and hence an uptick in defensive
derivatives applications. Meanwhile, the market's performance will continue
to make derivatives a cost-effective way to get equity play for nontraditional
players and cautious stock pickers.
"One can't help but be optimistic about the future," says Gastineau of AMEX. "No matter how you slice it, equity derivatives remain a much
smaller market than interest rate and currencies. And we are likely to see
continued growth," he says.
The stock market crash of 1987 almost killed off retail interest in derivatives products. Now, a decade later, the retail market is showing new strength.
Joseph Rizzello, executive vice president at the Philadelphia Stock Exchange (PHLX), said he was amazed at the size of the crowds at a recent a retail
options conference in Los Angeles. "I was astonished by the degree
of interest," says Rizzello, who believes educational efforts by the
likes of the Options Clearing Corp. and the various exchanges are now bearing
Retail investors have shown keen interest in foreign markets, and in
cost-efficient access to them via products like WEBS (world equity benchmark
shares). Structured like open-ended funds, the one-year-old WEBS are based
on 17 Morgan Stanley country indices and listed on the AMEX. "In a
way," says the AMEX's Gastineau, "our timing could not have been
worse. The funds were launched just as the U.S. domestic market took off."
But, he says, "in past two months there's been a greater and greater
degree of interest in the product."
While some money flowed from investors shut out of country baskets discontinued by the NYSE, most is clearly new money. So far, Japan and Italy have been
the most successful WEBS. In fact, interest has been so keen that AMEX has
applied to list options on WEBS.
SEC approval is expected by mid-year for other WEBS options. But the
SEC may not allow AMEX to list options on WEBS, which invest in markets
that do not have an information-sharing arrangement with the United States,
even though the WEBS are listed and the investors who can invest in their
derivatives would have to prove a greater degree of sophistication.
Improving Performance Measurement
Institutional investors live or die by performance benchmarks, and the
measuring tool often determines which techniques they use. Finance theoreticians
and their software-development companions are beginning to build portfolio
analysis tools that accurately measure the effects of derivatives. "There
is a growing interest in performance attribution and analysis," says
Mark Rubenstien, a professor at Stanford who is credited with the invention
of the binomial option model. Rubenstien is helping software firm Barra
incorporate the skewed return profiles of options into its performance attribution
Conventional portfolio analysis relies on standard deviation to arrive
at a risk-adjusted return on investment. Derivatives, however, produce abnormal
distributions that are skewed to the left or the right, the risk of which
is not captured by standard volatility measures.
Ironically, conventional measures penalize options buyers and reward
sellers because they ignore the potential for high-order events (loss or
gain) but take into account the fatter returns produced via earned premiums.
"I find [the trend toward better measurement] very encouraging,"
says Joanne Hill, vice president of equity derivatives research at Goldman
Sachs, with respect to a new tool from Frank Russell Co. that analyses downside
risk, not just symmetric risk. "One can only hope that more such tools
will emerge," she says.