Market Report | Equity Derivatives

With volatility rising from historic lows on the equity derivatives market, investment banks are finding renewed interest from clients among nonfinancial corporations.

During the first nine months of last year, when volatility on the options market plumbed historical lows, investment bankers complained that it was hard to get companies to buy derivatives that were little more than insurance against wide swings in stock prices.

Bankers aren’t complaining anymore. Since late September, volatility has spiked as oil prices have fallen and US large-cap stocks have soared. This year, they expect their corporate clients to rely more on equity derivatives than on cash to finance share repurchases, stock options, rights issues and even mergers and acquisitions.

“With higher volatility, there is heightened focus on the usefulness of hedging,” says William Brett, a managing director in the Equity Linked Origination Group at Credit Suisse in New York. “If the market stays strong, particularly with a number of tech companies having gone public, we expect more and more companies will utilize equity-linked securities to finance growth.”

There’s already evidence of growth in the buybacks arena. During the 12 months through September 30, companies in the S&P 500 Index spent $143.4 billion buying their own stock, up 27% from the same period a year earlier, according to research firm FactSet.

Many companies are using accelerated share repurchases, which leave all the execution risk with their investment banks. Put options, which are options to sell stock at a certain price, are usually embedded in these buybacks to tailor the exposures. In some deals, for example, the investment bank guarantees that the company will pay no more than a fixed premium to the current share price.

“The treasury staff doesn’t need to manage it on a daily basis,” explains Brett. “They can basically go to an investment bank and say, ‘I want to be guaranteed that I can execute at the average price over some period of time.’” Investors take notice of an accelerated share repurchase because they see it as a commitment to purchase the fully “authorized” amount of shares. Because the issuer pays cash up front, the process is not easily reversed.

“Clearly, adding a put-option sale as a component of a stock buyback is a stronger signal to investors, and you see a better price reaction,” says J. Randall Woolridge, a finance professor at Pennsylvania State University’s Smeal College of Business.

Now M&A is likely to get a boost from the derivatives markets as well. “We have worked with companies to structure programs [applying] accelerated share repurchase technology to acquire strategic equity positions in another company—as part of a joint venture where they have agreed to make an investment in their partner,” says Brett.

Corporations also buy their own stock to keep it from getting diluted by the issuance of new shares as compensation for their employees—typically in the form of call options, which are options to buy new shares. Jim Osman, CEO of The Edge, a management consulting firm in London, predicts that increasing numbers of companies will issue stock options that will be linked to employee performance.

Rights issues, which represent an option to purchase shares, are expected to become more common as companies cash in on the bull market. Globally, public companies raised a total of $51.5billion in 119 rights issues in 2014, nearly double the
$28.1 billion they raised in only 88 rights issues in 2013, according to Dealogic.

To be sure, the equity derivatives market is still largely driven by corporations that have issued convertible bonds, which convert debt to equity at a predetermined price, and use derivatives to avoid diluting their equity, explains Peter Bible, chief risk officer at EisnerAmper, an accounting firm in New York. But this year derivatives desks can expect to get a lot busier.