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Trading and Capital-Markets Activities Manual

Instrument Profiles: Equity Derivatives
Source: Federal Reserve System 
(The complete Activities Manual (pdf format) can be downloaded from the Federal Reserve's web site)

GENERAL DESCRIPTION 

The term ''equity derivatives'' refers to the family of derivative products whose value is linked to various indexes and individual securities in the equity markets. Equity derivitives include stock index futures, options, and swaps. As in the interest-rate product sector, the overthe-counter (OTC) and futures markets are closely linked. Banks are involved in these markets in a variety of ways, depending on their customer base. Some banks are actively involved as market makers in all products, while others only use this market to satisfy customer needs or as part of a structured financial transaction. 

CHARACTERISTICS AND FEATURES 

Equity derivatives range in maturity from three months to five years or longer. The maturities in the OTC market are generally longer than those in the futures market. However, maturities in the futures market are gradually changing with the development of the LEAPs (Long-Term Equity AnticiPation) market on the exchanges. As with other futures markets, there is a movement towards more flexibility in the maturities and strike prices of equity derivitives. The following are the major instruments that comprise the equity derivatives market and are available for most major markets around the world: 

  Equity swaps are transactions in which an exchange of payments referenced to the change in a certain index and an interest rate are exchanged and are usually based on a fixed notional amount. For example, counterparty A may pay a spread over LIBOR to counterparty B and receive the return on a specified equity index. These swaps are documented using standard ISDA documentation. Some of these transactions also have a currency component and in many cases are done as quantos.1 
  Stock index futures are futures on various stock indexes and are traded on most of the major exchanges. 
  Stock index options are options on either the cash value of the indexes or on the stock index futures. 
  Equity options are options on the individual stocks and are also traded on most major exchanges. 
  Warrants are longer-term options on either individual stocks or on certain indexes. They are popular in Europe and Asia (especially Japan). 
  Equity-index-linked notes are fixed-income securities issued by a corporation, bank, or sovereign in which the principal repayment of the note at maturity is linked to the performance of an equity index. The formula for principal repayment can reflect a long or short position in an equity index and can also provide an exposure to the equity market which is similar to an option or combination of options. 
  Other instruments include ADRs (American Depository Receipts), and SPDRs (S&P 500 Depository Receipts). 
  Index arbitrage is strictly not a product, but an activity; however, it is an important part of the equity derivatives market. 

As its name implies, index arbitrage is the trading of index futures against the component stocks. As these markets have developed, various enhancements have been made to them, such as the introduction of futures on individual stocks. Some of the more structured deals that banks are involved in use more than one of the above products. 

1. Quantos (guaranteed exchange-rate options/quantity adjusting options) are cross-border equity or equity index options that eliminate currency-exchange-rate exposure on an option or option-like payout by translating the percentage change in the underlying into a payment in the investor's base currency at a spot exchange rate set at the start of the contract. The investor holding a quanto option obtains participation in a foreign equity or index return, denominated in the domestic currency. Currency exchange rates are fixed at issuance by setting the option payoff in the investor's base currency as a multiple of the foreign equity or index rate of return. The rate of return determining the payoff can be positive (calls) or negative (puts). Guaranteed-exchange-rate put options are more common in some markets than guaranteed exchange-rate call options.

USES 

Equity derivatives are used for investment, hedging, and speculative purposes. The growth in this market has coincided with developments in other derivative markets. Users and customers of the banks have shown increased interest in equity derivitive products for purposes ranging from hedging to speculation. Some of the major users of these products are investment funds. Some banks also use them to hedge their index-linked certificates of deposit (CDs) (these are longer-term CDs, whose principal is guaranteed and whose yield is linked to the return on a certain stock index, for example, S&P 500). Some corporations also use equity derivatives to lower the yield on their issuance of securities. Some speculators (hedge funds) might use equity swaps or options to speculate on the direction of equity markets. 

Equity-index-linked swaps are often used as an overlay to a portfolio of fixed-income assets to create a synthetic equity investment. For example, a portfolio manager may have a fixed-income portfolio whose yield is based on LIBOR. The manager can enter into an equity-index-linked swap with a bank counterparty in which the manager pays the bank LIBOR and receives the return on an equity index, plus or minus a spread. If the portfolio manager earns a positive spread on the LIBOR-based investments, an equity-index-linked swap may result in an overall return which beats the market index to which the portfolio manager is evaluated. For example, if the LIBOR-based portfolio yields LIBOR + 20 basis points, and the manager enters into an equity-index-linked swap in which he or she pays LIBOR flat and receives the return on the equity index flat, the manager will receive a return on the equity index plus 20 basis points, thus outperforming the index. In this way, equity-index-linked swaps allow portfolio managers to transfer expertise in managing one class of assets to another market. 

Equity-index options, warrants, and futures are often used as hedging vehicles. A portfolio manager, for example, can protect an existing indexed equity portfolio against a decline in the market by purchasing a put option on the index or by selling futures contracts on the index. In the case of the put option, the portfolio will be protected from a decline in the index, while being able to participate in any future upside movement of the index. The protection of the put option, however, involves the cost of a premium which is paid to the seller of the option. In the case of selling futures contracts on the index, the portfolio is protected against a decline in the index, but will not be able to participate in future upside movement in the index. Unlike the put option, the futures contract does not involve an up-front payment of a premium. 

Equity-linked options are also used by portfolio managers to gain exposure to an equity market for a limited amount of capital. For instance, by purchasing a call option on an equity index, a portfolio manager can create a leveraged position in an equity index with limited downside. For the cost of the option premium, the portfolio manager will obtain upside exposure to an equity market on the magnitude of the full underlying amount. 

DESCRIPTION OF MARKETPLACE 

Sell Side 

The major sell-side participants in this market can be divided into three groups: investment banks, exchanges, and commercial banks. Investment banks have the greatest competitive advantages in these markets because of their customer base and the nature of their businesses and, therefore, have the largest market share. While commercial banks have much of the necessary technical expertise to manage these instruments, they are hampered by regulations and lack of a customer base. 

The underlying instruments for equity derivative products are primarily the various stock indexes traded around the world. Even though there is a lot of activity in the individual stock options, banks are mostly active in the derivatives market on the various indexes. Their involvement in the market for individual stocks is affected by various regulations restricting bank ownership of individual equities. 

Buy Side 

Buy-side participants in the equity derivatives market include money managers; hedge funds; insurance companies; and corporations, banks, and finance companies which issue equity securities. Commercial banks are not very active users of equity derivatives because of regulations restricting bank ownership of equities. 

PRICING 

Because of the large volumes traded in equity derivatives markets, the pricing of most of these products is very transparent and widely disseminated-at least for the products that are based on the equity markets of the major industrialized countries. This transparency does not hold true for the prices in some of the developing countries or those countries which are highly regulated. The pricing of some of these products is also affected by tax considerations and regulatory constraints for certain cross-border transactions. As with some of the other derivative markets, there is less transparency for structured products, especially those that involve some of the swaps that include exotic options in both the interest-rate and index components. 

HEDGING 

Since banks' activities with customers often involve non-standard maturities and amounts, equity derivatives instruments are often hedged using exchange-traded instruments. The hedges take the form of combinations of the products that are available on the relevant exchanges and also involve the interest-rate markets (swaps and futures) to hedge out the interest-rate risk inherent in equity derivatives. 

The risks of individual equity securities, or a basket of equity securities are often hedged by using futures or options on an equity index. This hedge may be over- or underweighted based on the expected correlation between the index and the individual security or basket of securities. To the extent that the underlying and the hedge instrument are not correlated as expected, the hedge may not be effective and may lead to incremental market risk on the trade. 

RISKS 

Market Risk 

Market risk in equity derivative products arises primarily from changes in the prices of the underlying indexes and their component stocks. There is also correlation risk associated with hedging certain transactions with the most liquid instrument available, which may be less than perfectly correlated with the instrument being hedged. 

Interest-Rate Risk 

Interest-rate risk in equity derivative products can be substantial, especially for those transactions with relatively long maturities. The implied interest rate is a very important component in the calculation of the forward prices of the index. For hedges that use futures to closely match the maturities of the transaction, interest-rate risk is minimized because the price of the future already has an implied interest rate. Interest-rate risk may arise in those transactions in which the maturity of the transaction is longer than the maturity of the hedges which are available. In swap transactions, this may affect the hedging of implied forward cash flows. In certain cross-border transactions, additional risks arise from the necessity of hedging the non-domestic interest-rate component. 

Volatility Risk 

A substantial portion of transactions in the equity derivatives market have option components (both plain vanilla and, increasingly, various exotic types, especially barrier options). In certain shorter-dated transactions, hedges are available on the exchanges. But when the maturity is relatively long, the options may carry substantial volatility risks. These risks may be especially high in certain developing equity markets, in which the absolute level of volatility is high and the available hedges lack liquidity. 

Liquidity Risk 

Liquidity risk is not significant for most equity derivative products in the major markets and for products with maturities of less than a year. Liquidity risk increases for longer maturities and for those transactions linked to emerging markets. 

Currency Risk 

Currency risk is relevant for cross-border and quanto products. As these transactions are often dynamically hedged by the market maker, currency risk can be significant when there are extreme movements in the currency. 

ACCOUNTING TREATMENT 

The accounting treatment for equity derivatives, except those indexed to a company's own stock, is determined by the Financial Accounting Standards Board's Statement of Financial Accounting Standards (SFAS) No. 133, ''Accounting for Derivatives and Hedging Activities.'' (See section 2120.1, ''Accounting,'' for further discussion.) Derivatives indexed to a company's own stock can be determined by Accounting Principles Board (APB) Opinion No. 18, ''The Equity Method of Accounting for Investments in Common Stock,'' and SFAS 123, ''Accounting for Stock-Based Compensation.'' 

RISK-BASED CAPITAL WEIGHTING 

The credit-equivalent amount of an equity derivative contract is calculated by summing- 

1. the mark-to-market value (positive values only) of the contract and 
2. an estimate of the potential future credit exposure over the remaining life of each contract. 

The conversion factors are listed below.

                                                Credit-Conversion
Remaining Maturity                   Factor 
One year or less                         6.00% 
Five years or less                       8.00% 
Greater than five years              10.00% 

If a bank has multiple contracts with a counterparty and a qualifying bilateral contract with the counterparty, the bank may establish its current and potential credit exposures as net credit exposures. (See section 2110.1, ''Capital Adequacy.'') 

LEGAL LIMITATIONS FOR BANK INVESTMENTS 

Equity derivatives are not considered investments under 12 USC 24 (seventh). A bank must receive proper regulatory approval before it engages in certain types of equity-linked activities. 

REFERENCES 

Allen, Julie A., and Janet L. Showers. Equity-Index-Linked Derivatives, An Investor's Guide. Salomon Brothers, April 1991. 
Federal Reserve Bank of Chicago. The Equity Derivatives Market: A Product Summary. February, 1997. 

Continue to CREDIT DERIVATIVES

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