The days when large corporations refused to deal in what were seen as “dodgy” derivatives are long gone. Now, equity swaps, bespoke equity options and even volatility swaps are all used to hedge corporate activity.

However, the wariness of the past is in some cases still being felt, and the rapid growth in the trading of equity derivatives over recent years plus the myriad of products on offer are causing their own problems. Alongside these issues, new accounting rules are exposing corporate treasurers to areas of derivative theory they never before had to consider.


Seymour: Derivatives
activity can be hard
to decipher when
corporates outsource

At the end of 2006, Hewlett Packard entered into a structured equity transaction with BNP Paribas to hedge possible stock dilution associated with its employee compensation program. “HP wanted to reduce potential dilution as a result of employees exercising their stock options,” says BNP Paribas’ head of strategic equity, Janet Kim. HP’s stock price had risen 30% over one year, and commonly used buy-back strategies failed to meet all of HP’s needs—namely, capping the price paid per share, providing downside protection and ensuring the impact on outstanding shares would be spread evenly over time.

The deal, called a prepaid variable repurchase transaction, involved using an options collar of selling put options and buying call options with different strikes. Hewlett Packard paid BNP Paribas $1.7 billion upfront, and the bank agreed to deliver around 1 million shares back every week over the course of a year with a cap of $33 (far below an average of $38 at the time) and a floor of $24.

“It is thought to be the largest structured repurchase program in US history and differs from most conventional accelerated share repurchase programs because we have put a mechanism

in place that has real price protection,” says Kim. “I think the use of derivatives by corporates has become more acceptable, but what matters is whether their use fits in with the treasury department’s overall risk management strategy. At the end of the day, no two transactions are ever the same,” she adds.

The Dark Side of Derivatives

Mergers and acquisitions in the 1980s were dominated behind the scenes by derivative trading. “You could just buy stock and then get a lever on a forward part of stock by buying an option without ever having to declare a notifiable interest,” says one industry expert. Although the rules have changed slightly today, until formally entering a takeover period it is still possible to quietly take up derivative positions—a fact that still makes corporates nervous.

In October 2006 Mike Ashley began an attempt to reverse his Sportsworld chain into Blacks Leisure. The process has proved controversial, though, as Ashley built up his 29% stake through derivatives before converting his holding into directly owned shares, allowing him breathing time before disclosing his intentions. Sportsworld sales soared 45% over 2005 to £905 million, unlike Blacks, which has seen its shares slump after a string of profit warnings, with pre-tax profits totaling only £21.4 million on sales of £297.2 million.

“At the moment he is just sitting with a disclosed substantial holding,” says Martin O’Donovan, assistant director of policy at the Association of Corporate Treasurers (ACT). “Corporates get very anxious about other people using equity derivatives, as it does allow a stalker to creep up on you,” he adds.

Jonathan Seymour, head of equities at European derivatives exchange Euronext Liffe, says what makes corporate activity harder to decipher is the fact that in many cases where a corporate is using derivatives as part of its own pension portfolio, it can often outsource this trading to a fund manager. “Normally, the fund or corporate manager would be looking to ensure that the cash is working for them against their benchmark in equities or bonds. The question is where a corporate would use equity derivatives in specific ways that a fund manager doesn’t, except during takeovers, and in that sense I don’t draw much distinction,” he explains.

Individuality and Innovation

With the diversity of products has come an increase in the variety of ways derivatives can be used when there is a desire to do so. Although not an everyday activity, corporate treasurers are now competent at taking an equity swap on their own stock or on that of another company, or hedging an individual stock’s performance against an index such as the S&P; 500. “There are so many ways for capital efficiency and for tax efficiency that are possible from synthetic structures and different types of equity exposure,” says Brad Bailey, senior analyst at research firm Aite Group. Equity swaps give funding, tax and collateral advantages. Dividend swaps are very popular in Europe for their tax advantages, and variance swap growth exceeded 100% over 2006, largely driven by hedge fund and institutional investors.

There is constant innovation from Wall Street aimed at the corporate client base. “I think that the growth numbers of equity derivatives published by International Swaps & Derivatives Association and Bank for International Settlements [BIS] with regard to equity derivatives do not reflect the very fast growth in some specific areas which has largely been fueled by corporate activity,” says Bailey.

Since a seminal case where chemical giant ICI in the early 1990s, after spinning off Zeneca, lost many younger members of staff and quickly needed to shift its pension strategy toward an older workforce, corporate bodies have gotten more sophisticated and have begun writing their own options. “ICI has become a classic case study,” says an industry expert. “Charles Amos, the treasurer at the time, purchased put options in the FTSE 100 and call options in the fixed-income market. It remains a template to a straightforward trade of options.”

However, in today’s marketplace corporate institutions are going one step further. By creating a trading instrument on a stock held in its individual pension portfolio after a period of high volatility, it is possible to charge high premiums and thus garner another source of revenue for the company.

However, this asset class with such a diversity of trading participants and increasing array of bespoke products has not developed without problems. In early January James Burrus, a senior FBI officer, admitted that stock options account for one-eighth of the FBI’s entire corporate fraud caseload. Because of the malpractice and mispricing of options, largely before the implementation of 2002’s Sarbanes-Oxley regulation, the bureau has 61 outstanding cases.

And with $5.36 trillion outstanding in OTC equity options alone in mid-2006, according to BIS, a backlog in confirmations that was seen in credit derivatives markets the year before is now being addressed by the New York Federal Bank and 16 major OTC dealers in the equity arena. “There are a lot of issues around the standardization of trades, and that is holding back growth. Equity derivatives still have very long confirmation times, and equity products tend to have very short lives. Sometimes a counterparty can be waiting for confirmation longer than the duration of the contract,” says Bailey.

With high-profile cases such as HP and Ashley’s buyout of Blacks firmly in the media spotlight, the advantages of derivatives for a corporate’s treasury department are being heralded to all. If they can shed their shady reputation and the backlog of confirmations can be reduced, there is no reason for treasurers to back away from dealing in derivatives.

Natalie Halliday