Equity Derivative Strategies Replace Some Stock Issues

Tuesday, June 10, 2003

Jennifer Morris, Tailored To The Times, http://

Equity Derivative Strategies Replace Some Stock Issues

Abstracted from: Tailored To The Times

By: Jennifer Morris

Euromoney - March 2003, Pgs. 32-35

Why equity derivatives make sense. During the bull market, CFOs and other financial executives had little incentive to choose complex equity derivative deals over a simple, straightforward equity issue. Yet with the bear market now entering its fourth year and the need to obtain financing still pressing, Jennifer Morris observes that many are now turning to equity derivative alternatives. They hope to shore up balance sheets, sell noncore assets, and achieve goals similar to what issuing equity accomplished in better times. Equity derivatives also meet the need for discretion, since selling large blocks of equity in the open market might send out a warning signal and depress stock prices. Other companies turn to private issues rather than face the unpredictability of public markets.

Hedging with a series of puts or calls. The author describes several alternatives to issuing stock, including a hedging arrangement in which the company buys an out-of-the-money put option from a relationship bank, priced at 10% below the current share price, then sells another one at 70% of the current price to reduce the premium. The arrangement provides protection as long as the stock does not fall more than 30%, yet it allows the company to benefit from a rising share price. Others sell forward by agreeing on a future price with a bank. To hedge, the bank then borrows the stocks and sells them. Using a put option to accomplish the same objective would be riskier, since the stock price could exceed the put's strike price at maturity. Alternatively, companies might sell a call option back to the bank to subsidize the premium. The popularity of this classic equity collar has decreased with falling interest rates, since banks find it difficult to charge enough interest to make the deals cost-effective. Writing calls which can fetch an attractive premium because of market volatilityor lending stock allows the company to receive premium payments from a bank but requires it to forgo any appreciation beyond the option strike price. A higher strike price would allow for more upward movement but would reduce the premium.

Sitting tight. Of course, some companies are simply biding their time and waiting for the equity markets to improve. While this may be a viable strategy, it does not allow them to pay down expensive debt or monetize a stake. In weighing the pros and cons of equity derivative strategies, the author suggests considering whether the cost of debt associated with each will exceed the rate of appreciation on assets. The use of these strategies has gained acceptance as companies become increasingly familiar with their structures and advantages. With the variety of options available, many of which offer tax as well as funding benefits, only companies expecting a near-term recovery in share prices have a reason for inaction.

Abstracted from Euromoney


published by Euromoney Institutional Investor Publications


Nestor House, Playhouse Yard, London EC4V 5EX, England.

Return to Library of Business Information