Vol rise boosts activity

IFR Derivatives 2008
10 min read

The rise in volatility in the past year has had a positive effect on institutional and corporate activity when it comes to equity derivatives, helping to counter the drop off in volumes on retail structured products. Innovative pay-off structures are no longer the driver so fringe aspects of the business have grown in prominence, such as equity financing and the hidden asset classes of variance, correlation and dividends. Owen Wild reports.

The past 12 months have inevitably changed the demands investors make of equity derivatives teams. Some business lines have gained substantially from this, particularly equity financing. The lending of cash against pledged equity stakes has taken place for decades, but in the past 12 months there are few banks that have not been active in that area, including those that do not have established equity businesses. Volumes of such transactions have been at record levels, but the falling markets of the past six months put many of these deals under pressure.

The growth in equity financing was a natural result of increasingly challenging credit markets. With the ability to borrow on an unsecured basis more constrained, investors pledged existing equity stakes in non-recourse loans. Yet the flawed structuring of many of these trades meant that the drop in equity markets in January caused a bout of restructuring and unwinds. Some of these were unable to be restructured after missed margin calls and banks were left with losses having provided deals with loan-to-value ratios of up to 85%.

The main problem was poor management of risk by banks that reflected bull market sentiment and it was only in early 2008 that these were finally restructured with equity derivative components.

Equity derivative teams were involved in deals throughout to assess the underlying stock on the basis of the size of the stock and its liquidity, but were often not asked to construct hedges. Most loans were then structured as swaps, with a small proportion as collars.

The collar structure has become more widely used as gap risk is reduced because the bank gradually sells stock as the market moves closer to the strike of the put. With a swap structure the borrower was hit with margin calls when the value of the stock fell and many struggled to post increased collateral in time, especially when markets dropped so sharply that several margin calls could be received a week. Banks are also using equity derivatives to provide a floor value for the underlying stock.

The collapse in equity markets post-summer has again put these trades under stress, with some unable to be restructured any further. The failure of the Icelandic banks prompted several equity placings in October as the banks’ borrowing was unwound along with loans it had given. This saw RBS, for example, sell a 10% stake in Nordic financial firm Storebrand which Kaupthing had pledged on a loan. Kaupthing loans were also recalled, prompting a series of sales, particularly for Robert Tchenguiz who saw his stakes in Mitchells & Butler and Sainsbury’s sold.

The equity financing business has been criticised by some for high loan to value ratios and overlapping trades where several shareholders may pledge collateral in the same company. In that case, the unwind of one loan would exacerbate any falls and cause others to fail. This problem was known to be prevalent in Russia where many of the oligarchs are highly leveraged. The massive drop in the local market post-summer has left oligarchs having to sell some of their investments to release cash following margin calls.

For instance, Kostyantin Zhevago had to sell down his majority stake in Ferrexpo after a margin call from JPMorgan for a loan against the stake. Oleg Deripaska was also hit and had to sell his 9.99% stake in Hochtief after a margin call from Commerzbank, which came shortly after having to pass his 20% stake in Canadian auto firm Magna International to BNP Paribas.

“We are seeing triggers being breached and positions getting liquidated in the margin lending market, but our strategic approach to equity financing means we have been able to manage our loan portfolio without any fire sales into the market,” said Ian Holt, global head of the strategic equity transactions group at Deutsche Bank. “We have always offered margin lending, but whenever possible we have structured client solutions using derivatives which allow you to dynamically hedge the transaction and avoid the gap risk that exists in margin loans. Gap risk in these markets is significant, with tail risk becoming a daily reality, leading to a collapse in the underlying collateral, followed by liquidations that are giving rise to losses for both clients and lenders alike.”

Those familiar with the collar structure and hedging the resulting exposure are now able to choose the trades they wish to enter as other houses are not keen to take on gap risk. The losses that have been incurred in January and October are already reducing the number of banks active in this space.

Corporate pain

Corporate activity has been impacted by the rollercoaster events of the past quarter as firms look to simplify the products they use and reduce counterparty risk. Complexity has been an issue, with several firms finding themselves caught out by making bets on market performance. This has led corporates to now buy structured products with capital protection, a structure normally targeted at retail investors.

This follows the painful experience of Japanese real estate firm Urban Corporation, which used the proceeds of a convertible bond issue to enter an equity derivatives transaction with BNP Paribas. The market believed the firm had raised ¥30bn (US$275m), while in fact the company had entered a series of swap transactions that linked proceeds to trading in Urban stock over two weeks. Urban handed the ¥30bn to BNPP and received payments based on the VWAP and trading volume in its stock each day. As the stock fell the payments dropped below the company’s expectations and it filed for bankruptcy protection weeks later.

Corporates have also recognised counterparty risk as an issue, though it is hoped that government packages announced in early October could help those dealers perceived to be weak. The fall of Lehman Brothers was a massive issue due to the amount of inflation hedges written by the firm, but some corporates also saw their call-spread overlay convertible bonds undermined as the derivative disappeared. The call-spread overlay is commonplace on convertible issues in the US in particular as firms seek to boost the exchange premium to reduce dilution. The embedded call option is repurchased and warrants sold at a higher strike price. Several firms had completed call spread trades with Lehman and saw them disappear overnight. The call spread can often cost 10%–15% of proceeds.

The issue of counterparty risk only really impacted behaviour across the market once Lehman Brothers failed, but the reaction was then dramatic. Bankers said there was a clear move away from dealers to trading on exchanges, where possible, while some hedge funds simply ceased any OTC activity.

One head of equity flow derivatives said the situation for many investors is now quite simple. “Investors have said to us ‘where it is possible to trade something similar on exchange then I will’,” he said.

Added complexity

Countering this is the indication that some investors are willing to look at new OTC products in order to seek returns uncorrelated to direct equity investments. High among these are the so-called "hidden assets" of variance, correlation and dividends. Across the Street the marketing effort has been boosted in this area in 2008, but progress is slow outside of the hedge fund space. It is a new concept for investors to play these assets and does not play to their core stock-picking ability.

Initially fund managers are looking at implied volatility as an overlay for their equity portfolio and recent performance has been an exceptional marketing tool. Bankers report that the back-testing this has provided is now outweighing the resistance to something new and over-the-counter. But the number of firms active has lagged as the internal decision-making process can take up to six months for funds. Yet in September one bank said it had a client that had cut this to just six weeks due to the desire to move quickly.

Whether funds move on from overlay to taking directional views on volatility remains to be seen, but analysts highlight that the macroeconomic picture is a significant risk in expressing a view. JPMorgan analysts highlighted in October that S&P Dec 09 implied variance could be sold at over 30, which would have made money in 56 of the previous 57 years, yet the potential of a long lasting global recession would lead to hesitancy over shorting vol at even that level.

The level of perceived risk in the current market has led to the launch of a new product that aims to be a low-risk derivative: the clipper. The clipper, which is effectively a zero-cost collar that caps the gain or loss against the movement of a stock, is currently being worked on by its creator Actuarial Holdings along with prime brokers. It is aimed at high volume traders like hedge funds. Clippers are traded and cleared through Actuarial Holdings making them a safer option for those looking to limit potential losses.