The use of equity derivatives has risen dramatically in recent years. In Europe, the volume of Eurex exchange-traded equity derivatives in 2006 had reached €807bn by the end of October. This was already 60 per cent up on the 2005 total of €608bn. It was also more than double the total figure in 2003 of €376bn.
The products are becoming increasingly popular with institutional investors for a number of reasons. Gerry Fowler, European equities derivatives strategist, Citigroup, says: “Institutional investors in Europe have worked for several years to become compliant with Ucits III. The cut over date is 13 February 2007. This legislation will give them a broader, less prescriptive, more ideological framework from which to do their portfolio management. Therefore it will allow them to use derivatives and leverage, although there are still restrictions.”
Mr Fowler says that many asset managers have been working on back and middle office issues involving booking and valuing derivative products. Now these are being resolved, they are considering what strategies they can employ.
According to Mr Fowler, most institutional investors will still focus on relatively simple derivatives products such as swaps. But interest is also emerging in the market for more sophisticated instruments such as options and variance swaps. This has been helped by the market volatility in May and June where the protection against downside performance that these products provide would have been useful.
Investment banks and asset managers haven’t been idle either. Many have worked on improving the equity derivative products that their institutional clients already use.
Shaun Wainstein, head of London equities and derivatives at BNP Paribas, says: “Some institutions have been using equity derivatives for a while. Often people write call or put options on their own portfolio in order to get extra yield. That is a more traditional use. But recently we have helped people do that in a more systematic way and packaged that strategy to make it more easily available. It means that, rather than the client having to do all the trading, risk position keeping and settlement themselves, they can access the returns of the strategy directly.”
Institutional investors are becoming increasingly sophisticated as well. Mr Fowler says: “There are a large number of funds that overwrite now because they have recognised that there are opportunities for alpha generation in derivative markets. It is still in its infancy. Derivatives are already used in their simple forms, like swaps and futures, but institutions are moving increasingly towards the more complex strategies involving options, for example.”
The most commonly used equity derivatives are futures, swaps and options.
Futures have been one of the main tools used by institutions. Mr Fowler says: “They are a cash flow tool whose main use has been to monetise positions very quickly. If institutions get new cash they can invest it in a future immediately and they then have time to implement stock-specific trades that better suit their trading view.”
Swaps can allow investors to access the market more efficiently and simplify the trading process. Instead of having to trade 200 individual securities and then manage the corporate actions within them, you can trade one swap with an investment bank. It is then the bank’s responsibility to deal with the execution risk and corporate actions that occur over time.
Mr Fowler says that swaps are also increasingly popular for expressing a “thematic” view. “For example, a fund is using a quantitative investment screen that selects only value companies. Every three months when Citigroup produces its rankings of value, momentum and growth stocks, this fund acts on those recommendations through a swap structure rather than the individual securities.”
Options can be more sophisticated but have been gaining in popularity. An option offers the buyer the right to buy (call) or sell (put) a security at an agreed price at a certain time.
One of the main ways that institutions use them is to reduce the risk of holding an asset. Mr Fowler says: “If you buy a put option, it means that, if the market goes down, you are protected from losses below a certain level. This is useful for investors who want to stay in the market because they believe in the fundamentals. But they may be worried about market volatility caused by anomalies such as the correction in May this year. There is an initial cost to owning the put option, but it protects you from a sharp decline.”
As well as protecting gains, options can also be used to enhance the yield in a portfolio. Overwriting is an option that does this and is gaining favour with institutional investors. This is a strategy that involves writing call options on equities that the writer already owns to generate maximum income from options premiums and dividends.
Mr Fowler says: “Overwriting has been very popular in the past couple of years. There is probably about €20bn in funds that are overwriters now in Europe. Some of that is coming from banks but a decent amount is from insurance and asset management companies.
“Although overwriting can underperform in a strong uptrending market, over the past 15 years, it has outperformed. This is because the derivative markets continue to price inefficiencies. Consistently applying this strategy can enhance the risk-return trade off – particularly if done intelligently by taking a view on the relative pricing of that option.
“People refer to selling options as getting paid to leave a limit order. If the share price is 80, you might make a trading decision that you don’t think it will go beyond 84 in the next two months. If it does, you will be happy to sell anyway, so why not sell a call option today? You might get one euro for that in which case you can add that to your returns as yield enhancement.
“It is the same with the put options. For example, we loved this sort of strategy on Tesco, when it was trading around £3. We had a strong view that Tesco should not and would not go below £3 in the short-term. If it did, we should buy the stock. Also the options were quite expensive on Tesco. We suggested people sell put options on the stock. In other words they would promise to buy stock in the future at £3 if the share price went below that. If it never went below that, then they are collecting the premium from having sold the put option in the meantime. That is the yield enhancing strategy.”
Another important factor in the equity derivatives market is the increase in activity of hedge funds. Mr Wainstein says: “Hedge funds are more active and more important, which is a critical area of development for us. It means there are many more assets under management available to take significant positions. For example, on dividend swaps we traded with hedge funds a total size equivalent to all the retail insurance done in Europe. Those are big sizes.
“This hedge fund appetite allows the major equity derivatives houses to take on more risks and to remanufacture and recycle risk and offer it to the institutions or the hedge funds.”
And, as in so many areas, hedge funds are driving innovation. Mr Wainstein says: “Some hedge funds are just looking for vanilla equity derivatives, short-term vanilla calls and puts, and perhaps variance swaps. But some are looking at more sophisticated products from dividend swaps to the more complex correlation or conditional volatility products.”
Another area of development in equity derivatives is the tailoring of instruments to meet institutional demand.
An example is Eurex which has introduced its Flexible Options Facility (called Flex) for all equity and equity options traded on the exchange. This offers institutional investors and portfolio managers customised, over-the-counter contracts combined with the reduced counterparty risk of a centralised clearing house.
Setting the price
It enables investors to set the exercise price, expiration date and exercise style of the investments.
 | Both investment banks and asset managers have been busy in this area too. Steve Aukett, director, at the financial solutions group at Insight Investment, says equity derivatives can play a part in an institution’s liability-driven strategy and as such would have to be tailored to their liability and risk profiles. |
Aukett: equity derivatives play a part in pension funds’ liability-driven strategy
He says: “Providing liability-driven solutions for defined benefit pension schemes and insurance companies often involves the use of equity derivatives as well as traditional liability-matching solutions such as inflation and interest rate swaps.
“For example, we have seen increased use of derivatives that enable the management of market risk and isolation of equity market risk from the manager skill component. If the client wanted to use this as a long-term option, we could put in place an ongoing, dynamic insurance protection strategy, known as constant proportion portfolio insurance (CPPI).”
He adds: “It uses futures to allocate between a risky asset such as equities and a non-risky asset like bonds and manage the mix based on a strategy. For example, as you move towards a protection level, you have to sell out of your equities, because you can’t risk losing any more money. So it is dynamically allocating between risky and non-risky assets.”
He says this is one in a series of different strategies that are tailored around the risk and return profiles of institutions.
There has been a suggestion that investment banks could snatch some business from asset managers in this area because they are more familiar with over the counter (OTC) products and can report on them. Asset managers have only been using these products for a few years and can’t provide reports.
Andrew Dyson, head of institutional investment for EMEA, BlackRock, says: “The institution has a specific threshold to protect. Because this is over the long term, it is more suited to specific OTC instruments. It is tailor-made because it has the client’s sensitivities hard wired into the design. But, because they are OTC, you also tend to be locked into them. An example is long-term options.
“The long-term element can be very effective while it lasts but people need to think carefully about what happens when the product expires. You need to make sure that you won’t exit the product and find yourself in a difficult position. If market conditions are not to your liking when these products expire, you need to make sure you have a sensible route forward.
“Also, while these things can be valuable, it is important to check that the price you are paying is justified by the value it brings. We see some outstanding examples of this and some less outstanding examples. Insurance is always valuable, but sometimes the price may be more than the value it brings to you.”
