Europe Leads The Way In Derivatives Development
As the trend toward using equity derivatives in corporate finance sweeps Europe, the situation in the US couldn’t be more different.

Companies have long used equity derivatives to help manage equity-related risk. Now they’re finding an array of other uses for them, although development in some markets, particularly the United States, has been stymied by the lack of clarity in accounting standards. In stark contrast, markets across Europe have seen nothing but growth over the past year, with new uses being implemented and new products explored.

How derivatives accounting will play out going forward is a big concern for many companies. Serge Marquie, global head of the strategic equity transaction group at Deutsche Bank, says, “The big issues have been with the lack of clarity in terms of what direction accounting changes were going to take.” In the United States, he says, the pendulum has swung toward relatively little use of derivatives. “For example, the typical put transaction: With accounting concerns and with stock values going consistently up, it just makes sense to buy stock outright rather than going into complex synthetic transactions,” he explains.

Marquie adds: “The big trend now in the US is really the addition of relatively plain-vanilla derivative transactions to classic public transactions. For example, it is very common to see the addition of a derivative strategy to a classic equity-linked transaction. In this case, it becomes essential to structure the derivative strategy in line with the accounting treatments of the public transaction.” The big push has been through the use of forwards instead of straight stock issuance. “In a bullish stock market environment, forward issuance allows the issuer to lock in higher market prices without committing to an actual issuance,” he says.

Europe Forges Ahead
Compared to the US, the European market has been alive with new issuance over the past year, and the use of corporate derivatives is growing within every product line. Philippe Parmenon, head of equity derivative sales at Société Générale, explains: “In Europe nearly every day there is a new transaction in the market, and corporates consider equity derivatives as useful tools with many different applications.”

One of the main uses, however, continues to be in equity risk management—for example derivative positions in a company’s own shares. François Forestier, global head of strategic equity at BNP Paribas, says: “Borrowing money through equity financing structures, such as prepaid forwards, structured REPO transactions and so on, is cheaper than straight loans. These transactions can be combined with hedging strategies in order to reduce exposure to market moves.”

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Forestier: “Using structured pay-offs with derivatives embedded may allow significant cost reduction.”

In addition, the demand for structured employee schemes is growing in Europe with implementation of the new International Accounting Standards (IAS) rules. Forestier explains: “Companies having to disclose fair market value of stock options they grant will search for new structures that might allow significant cost reduction while keeping attractiveness of the scheme for their employees.” The move is the same for Employee Share Ownership Plans, where the discount granted to the employees as an incentive to subscribe to newly issued shares is now accounted as an expense. He adds: “Using structured pay-offs with derivatives embedded may allow significant cost reduction.”

However, as in the US, there are still concerns over derivatives accounting under IAS, and some products, such as convertible bonds, have suffered as a result. Geoffroy Wallier, head of equity derivatives structuring and marketing at Royal Bank of Scotland (RBS), says, “Corporates have become more hesitant to use derivatives in general in order to comply with IAS 39 rules and especially in cases where the rules are not very clear—for example with the convertible.” A convertible can be accounted either as an equity instrument or an embedded derivative, depending on the treatment that the issuer adopts in its accounts.

Despite such anomalies, Europe has opened up to new products, according to Marquie—such as non-recourse financing of large undiversified equity positions—with various objectives, such as strategic acquisition or targeted investments. “The use of equity derivatives in this area is definitely in a growth phase, with a huge need for people to find assets and to acquire them in any possible way. Europe has been far and away the most exceptional environment globally for corporate equity derivatives this year,” notes Marquie.


Derivatives Present Opportunities

There are clear benefits in employing equity derivatives for emerging market companies, too, as Coca-Cola Femsa treasurer Ian Craig explains. “We have used them in the past, really on an opportunistic basis. The last time was during the Asian and Tequila crises,” he says. “Our share price was down so we used puts as a means to take a view on our stock price to make a profit on that.” Femsa is the largest Coca-Cola bottler in Mexico.

Craig says the group did not want to repurchase outright as it could have affected their share liquidity. “This is not generally an issue for US companies because the market is so liquid, but here it is very important as the market is not as liquid, so making many share repurchases would really impact our liquidity,” he explains.

Other emerging market companies can take similar advantage of fickle investor confidence and make money when stock prices are unduly low. However, because of the seeming complexity and risk of such products, it is usually only the top-tier entities that actually use equity derivatives opportunistically.

Asia and Japan are progressively becoming more active in the use of corporate equity derivatives strategies. “Especially in Japan, we have seen the return of corporate use of equity derivatives,” says Marquie. “Our big push in Asia has been in India, where we are seeing significant market development with the application of many of the strategies seen in more traditional markets.”

However, there are risks associated with the use of equity derivatives, some of which are well known in the market and not lightly ignored, according to analysts. A Fitch Ratings study of corporate derivatives use found that 11% of study participants had derivative positions in their own shares. As the study’s author, Roger Merritt, notes: “Positions such as forward purchases or written puts on a company’s own shares have led to unexpected losses in the past. Further, equity derivatives can have unexpected effects on reported debt.”

But Forestier at BNP Paribas says this should not be a big concern if the structure is set up properly: “The potential loss is not a real issue as long as the put option sale was originally disclosed properly, and this loss is equivalent from an economic point of view to the opportunity loss suffered by a company buying back its own stocks before a drop in share price.”

Derivatives Find Alternative Uses
The prime use for corporates has been in terms of equity risk management. But another use is also gaining in popularity among some top-tier corporates—that of investment management. Says Wallier at RBS: “Corporates have not been investing in capital-guaranteed enhanced investment for some time, but considering the very low level of interest rates, the important cash reserve that corporates now have and the new offerings on investor products allowing the combination of equity with other asset classes—such as FX, interest rate or commodities—I see corporates investing more in capital-guaranteed equity and hybrid-linked notes.”

This, however, is the domain of the largest, most highly sophisticated companies, which often look more like a financial institution than just a corporate. As Forestier notes, “Even if some equity derivatives structures are popular, thanks to tax or accounting gimmicks, the main market share remains on the fixed-income side.”