JEFFREY H. HARRIS Professor of Finance, University of Delaware, and Chief Economist, United States Commodity Futures Trading Commission

Transcription

1 CHAPTER 7 Equity Derivatives JEFFREY H. HARRIS Professor of Finance, University of Delaware, and Chief Economist, United States Commodity Futures Trading Commission L. MICK SWARTZ University of Southern California INTRODUCTION News about the stock market dominates the popular press. Since investors make stock investments based on their expectations about the future, stock market returns reflect investor expectations. For individual companies, however, the future may hold great uncertainty about firm performance. This uncertainty represents the risk of investing in a company. Derivative securities have been designed to manage these risks. Stock options, single stock futures, convertible bonds, warrants, and equity swap agreements can all be used to manage firm-specific risks. While developing portfolio theory, Harry Markowitz recognized that building portfolios of stocks can help to manage risk as well. The correlations between stocks in a portfolio can serve to reduce overall portfolio risk, even while individual companies remain risky. In this regard, portfolios can help to reduce firm-specific risk. However, without perfectly negative stock correlations, every portfolio also contains systematic risk that is not diversifiable. This portfolio risk also can be managed with a set of derivative securities. Options, futures, and swap products each help to manage portfolio risk. Among these, tailored swap contracts have experienced the most dramatic growth in recent years while futures and options products remain the most popular equity portfolio derivatives. According to Futures Industry Association (FIA) figures, global options and futures trading volume rose by 28 percent in 2007 (Burghardt 2008). This growth resulted in more than 15 billion futures and options contracts traded that year. By any standard, global growth in these markets has been robust for the past five years with annual growth rates of 30 percent in 2003, 9 percent in 2004, 12 percent in 2005, and 19 percent in FIA figures show that equity derivatives accounted for 64 percent of the increase in futures and options trading volume. We have benefited greatly from the comments of Jim Overdahl. The views expressed in this chapter are those of the authors and should not be viewed as those of the U.S. Commodity Futures Trading Commission or any of the commissioners. 103

2 104 Types of Financial Derivatives Increases in worldwide trading volume have largely mirrored the increase in volatility of the underlying equities markets. Market participants around the world seeking to hedge against volatility in the underlying equity markets are increasingly drawn to the equity derivatives markets. For instance, Asian demand for derivatives grew substantially in Trading volume on the Korean exchange increased by 9 percent during More strikingly, the Hong Kong exchange reported an increase in derivatives trading volume of more than 100 percent during Elsewhere in the world, growth rates have been even more dramatic with 214 percent growth in South Africa, for instance. From a worldwide perspective, increased trading volume mirrors the growth in contract originations. Although approximately 40 percent of derivatives originated in North America, derivative contracts are truly international in scope, with another 28 percent of contracts originated in Asia, 22 percent in Europe, and 7 percent in Latin America. As emerging nations develop financial systems, these countries are increasingly using derivatives to manage risk. Although volatility of the underlying assets drives much of the growth worldwide, some of the increase is due to more market participants using derivatives. Given the growing array of derivative choices options, futures, swaps, and their various combinations the choice of appropriate instruments can be difficult. In a 2008 Tabb survey (Nybo 2008) of financial institutions, liquidity considerations were rated as the top concern of asset managers when picking from the set of available derivative instruments. A full 70 percent of institutions listed liquidity as the biggest challenge in derivatives markets. In contrast to many other derivatives markets, nearly all equity derivatives markets have been developing greater liquidity over time. In response to greater comfort with liquidity levels, a majority (53 percent) of asset managers have relaxed their internal restrictions on trading options. STOCK OPTIONS Stock options represent risk management tools for individual company investments. As risk management tools, stock options typically are traded most actively when firm risk is high. It is unusual, for instance, to see stock options on utility companies, whose regulated status makes for largely predictable returns. Stock option trading flourishes in companies engaged in technology development, biotechnology and other higher-risk ventures. Where uncertainty reigns, stock options can serve to mitigate the risk of stock investing. Indeed, as the idiosyncratic risk of individual stocks has been increasing over time, growth in stock option trading has expanded concurrently. Options on individual stocks are, in fact, some of the most popular of the equity derivatives. Stock option trading volume, although driven by volatility, is tempered by liquidity considerations. Indeed, liquidity was identified as the greatest challenge for institutional investors during 2008, particularly for options on small-capitalization stocks. Technology, however, is playing an increasingly central role in providing liquidity sources to options trading. Liquidity in equity options markets is accessed across a variety of venues, including directly from traders on an organized exchange, through over-the-counter (OTC) option contracts, through direct access

3 EQUITY DERIVATIVES 105 via electronic market platforms, and through smart order routers that can access many of these venues automatically. As a result, sell-side institutions continue to design more complex and functional electronic systems that allow for greater access to and aggregation of liquidity. The complexity of stock option pricing slowed the development of electronic trading in these markets. While Nasdaq pioneered electronic equity trading starting in the early 1970s, it was not until 2000 when the electronic International Securities Exchange (ISE) brought serious electronic competition to options trading. Since 2000, the ISE has captured a significant market share in U.S. stock option trading. Just as Nasdaq has grown to trade more than 2 billion shares per day electronically, by 2010 approximately two-thirds of all stock option trading will be done electronically as well. The mechanics of options contracts are quite simple. Option contracts involve both a buyer and a writer. The buyer buys a form of insurance and the writer provides the insurance and is obligated by the terms of the contract. The buyer pays a premium to the writer at the beginning of the contract. The writer is then obligated to buy or sell the stock to the option buyer at a specified price during the length of the contract. Options traded on exchanges have rules requiring the writers of these contracts to show they can honor their contracts on a daily basis. Since the buyer pays the entire premium up front for these option contracts, there is no need to ensure the buyer can pay. An American option allows the buyer of an option to buy or sell the stock on or before the exercise date. A European option allows the buyer of an option to buy or sell the stock only on the exercise date. As a result, an American option with all other terms equal is worth at least as much as a European option. Call Options Stock option prices are affected by six variables: the stock price, the exercise price of the option, the time to expiration, the risk-free rate, the volatility and expected dividends during the life of the option. If the price of a stock rises, the value of a call option rises. Specifically, the value of a call option on the expiration date is V(call) = max(0, S X) where V(call) = value of the call S = stock price on the expiration date X = exercise price on the expiration date If the price of a stock rises, the value of a call option rises. The call option provides protection from an increase in the value of the asset. If the exercise price is lower, the value of the call option is higher. In addition to the stock price and the exercise price, the value of a call option is affected by the time to expiration, the volatility of the stock, the risk-free rate of interest, and the expected dividend of the stock. The value of a call option rises if the risk-free interest rate increases and all other factors remain unchanged. The impact of time affects American options differently from European options. An increase in time to expiration increases the value of all American options (puts

4 106 Types of Financial Derivatives and calls). Investors can choose to exercise their option among more time periods, encompassing more states of the economy. As a result, the value of an American option rises with an increase in the time to expiration. Since a European option can be exercised only on the expiration date, increasing the time to expiration may not increase European call values. Another factor affecting the value of a stock option is the dividend. Since dividends reduce the value of a stock, larger dividends reduce call values. Put Options The value of a put option on the expiration date is V(put) = max(0, X S) where V(put) = value of the put S = stock price on the expiration date X = exercise price The value of a put option increases as the value of a stock decreases. A put option provides protection from a decrease in the price of an asset. Like call, put options increase in value with an increase in volatility and an increase in the time to expiration (for American options). A put option decreases in value as the risk-free interest rate in the economy rises (opposite of the call option). The impact of the value of dividends distributed during the life of a put option is opposite the impact of a call option since dividends reduce stock prices. Two commonly used models for pricing options prior to expiration are the binomial model and the Black-Scholes model. These models can be used to demonstrate that options prices are very sensitive to volatility levels and where volatility is a concern options can be used for effective hedging. Stock Options on an Index A Tabb Group survey of financial institutions published in 2008 estimates that approximately 30 percent of institutional investors actively use options to gain exposure to or hedge the risk, with stock index options representing the most popular of all options. This percentage is expected to double in the next few years. In fact, financial institutions have made equity index options some of the most actively traded contracts in the world. On the basis of trading volume, the largest 10 equity index futures and options contracts worldwide are: (1) Kospi 200 options (2) E-mini S&P 500 Futures (3) DJ Euro Stoxx 50 Futures (4) DJ Euro Stoxx 50 Options (5) Powershares QQQQ ETF options (6) Standard & Poor s (S&P) 500 options (7) ishares Russell 2000 ETF Options (8) SPDR S&P 500 ETF Options (9) S&P CNX Nifty Futures (India) (10) E-mini Nasdaq 100 Futures

5 EQUITY DERIVATIVES 107 In the United States, the S&P 500, Dow Jones Industrial Average, Nasdaq 100, and S&P 100 are the most heavily traded index options. Stock index options are settled in cash. This feature simplifies the process at settlement, since no delivery of the underlying index is required. The relative simplicity at settlement also contributes to the popularity of index options as hedging instruments. For optimal or partial portfolio hedging with index options, the number of put options to hedge is proportional to the portfolio beta. Employee Stock Options Many employees receive stock options, which provide incentives to employees to take actions that benefit the firm. Top managers make key decisions that influence the value of the firm. By receiving a form of compensation that increases with the stock value, employees have incentive to take actions that are of benefit to other shareholders. In contrast to typical call options, employee or executive stock options are long-term call options on the stock many last 5 to 10 years and commonly they are not exercisable for at least 3 to 5 years. Employee options cannot be traded on exchanges (are illiquid), and new shares are issued at the time of exercise, diluting the value of existing shareholders. Furthermore, employees can take actions that affect the value of the option. For these reasons, employee stock options are more difficult to price than standard stock options. Convertible Bonds Although not originating as equity, debt issued as convertible bonds holds the potential to convert into stock under specific terms in the bond contract. In this regard, convertible bonds contain a derivative component related to the equity value. The holder of a convertible bond effectively holds a contract with a fixed bond component and a call option on shares of the firm. When the call component is out of the money, the convertible bond simply remains debt on the company balance sheet. However, if the call component is in the money, the bond can be converted into shares of stock. As with a call contract, holders have no incentive to exercise the conversion option early early exercise destroys the time value of the option. The optimal strategy for holders would be to sell the convertible bond to another investor and buy shares with the proceeds to reap the inherent time value of the option. However, the issuer typically would like holders to convert early, so many convertible bond contracts contain call provisions. Call provisions in convertible callable bonds give both the bond issuer and the bondholder options: The issuer has a call option on the underlying bond and the holder has a call option on the firm s stock. Although the holder receives no benefit from early exercise, the bond issuer does benefit from forcing conversion. By forcing conversion, the bond issuer eliminates the time value embedded in the conversion option. One difference between the value of the convertibility option and a simple equity option is the fact that conversion of the debt to stock leads to an increase in the company shares outstanding (e.g., employee stock options), diluting share value and creating a more complex pricing problem for the convertible debt at issuance.

6 108 Types of Financial Derivatives Warrants A warrant is a long-term call option that allows a warrant holder to buy shares directly from the firm at the exercise price. A small company might issue stock at $15 per share and allow stockholders to buy warrants for $1 per share. The warrant may allow buyers to purchase the stock at $30 per share anytime over the next five years. If the stock price rises to $40 per share within the next five years, the warrant holder could buy the stock at $30 per share (the company issues more shares so dilution occurs) and could sell the shares for a $10 profit on a $1 investment. As with convertible debt, the option to exercise a warrant also has time value, so early exercise is not likely. Since early exercise destroys the time value of the option, a warrant holder would always be better off selling the warrant and buying the underlying stock rather than directly exercising the warrant for shares. As with convertible bonds, the exercise of warrants forces the firm to issue new shares to the warrant holder, increasing the shares outstanding for a company. Exercised warrants also dilute share values. If the value of the firm never rises above $30 per share over the five-year time period, the firm just keeps the $1 premium for the warrant. Therefore, the firm raises cash at the expense of possibly sharing future gains with the warrant holders. EQUITY FUTURES Equity futures exist for both single stocks and portfolios of stocks. Worldwide, forward trading in stocks dates back more than a century in Swiss markets. Active equity futures markets in Europe, Asia, and Australia have existed for more than 20 years, with equity index futures representing the majority of trading volume. Although relatively lightly traded, single-stock futures have been traded in Sweden and Finland for more than a decade. While stock index futures have been traded in the United States for more than three decades, single-stock futures and narrow-based index futures became legal to trade in this country only after passage of the Commodity Futures Modernization Act (CFMA) in The CFMA ended an 18-year government ban on single-stock futures and narrow-based index futures, a ban that stemmed largely from regulatory jurisdictional disagreements. The combination of security (equity) features regulated by the U.S. Securities and Exchange Commission (SEC) and futures characteristics regulated by the Commodity Futures Trading Commission (CFTC) created a quandary that led to the effective ban. Although single-stock futures are designated as futures contracts, concerns about potential manipulation of the underlying stock(s) raised concerns from the SEC. Single-Stock Futures Single-stock futures have been developed as an alternative for managing the risk of investing in stocks. Single-stock futures offer a market to buy or sell the underlying stock at some future date, typically at some short horizon (within a year). They represent a somewhat lower-cost alternative to stock options, since entering into a futures contract requires only margins. Worldwide, and most predominantly in

7 EQUITY DERIVATIVES 109 South Africa, single-stock futures trade on a wide variety of stocks. As with stock options, however, trading is likely to be concentrated in firms where uncertainty is greatest. Although in the United States, single-stock futures typically are settled on a T+3 basis with the delivery of the underlying stock, the use of single-stock futures facilitates short positions in stock. By using single-stock futures, an investor avoids the costly logistics required for borrowing shares in a short sale arrangement. Further, the relatively low (20 percent) margins on U.S. single-stock futures make for a low-cost competitive alternative to options for hedging purposes. Single-stock futures are priced with a simple present value/future value relation. More specifically, the price of a single-stock future should represent the present value of today s stock price along with the present value of any future dividends that might be paid out before the futures contract expires. Mathematically, we can state that the value of a single-stock future F is F = (S o D)e rt where S o = current stock price D = present value of dividends paid during the life of the futures contract T = time to maturity (in years) r = continuously compounded risk-free rate of interests over the life of the futures contract Futures on Stock Indexes Some of the most actively traded futures contracts involve stock index futures. Stock index futures range from broad-based to narrow-based indexes. The most broadly traded index futures are based on country-specific indexes such as the S&P 500, the Financial Times Stock Index FTSE 100 (London-listed companies), the Deutschen Actien Index DAX 30 (Frankfurt-listed companies), and the Cotation Assistee en Continu CAC 40 (Euronext Paris-listed companies). Stock indexes based on other countries typically are narrower in scope. For instance, the Portugese Stock Index PSI-20 index includes 20 Euronext Lisbon-listed companies, with the top 5 firms representing approximately 75 percent of the market capitalization of the entire index. In the United States, OneChicago lists a number of narrow-based index futures. The indexes traded here are typically comprised of portfolios of four to seven stocks, many slanted toward Canadian stocks. Portfolio managers at mutual funds, hedge funds, insurance companies, and other institutions face systematic portfolio risks when they hold equity portfolios. Likewise, market makers and dealers who sell index products to clients also can be exposed to systematic risk. Stock index futures provide an efficient mechanism for managing this portfolio risk at a relatively low cost. Since entering into a futures contract requires only margin payments, these institutions can avoid the premium payment that accompanies index options.

8 110 Types of Financial Derivatives EQUITY SWAPS The equity swap market has emerged from the need for more tailored derivatives. Equity swaps, as the term suggests, involve two parties that swap payments based on the notional value specified as some portfolio of equities. The most basic equity swaps involve fixed-for-floating payments based on the underlying notional value. An investor (typically an institution) with exposure to equities in a portfolio is exposed to the risk of the stock market dropping in value. To hedge this risk using equity swaps, the institution could utilize an equity swap promising to pay the (variable) return on a broad stock index such as the S&P 500 in return for a fixed percentage payment based on the notional value of the underlying portfolio of stocks. The resultant cash flows provide a fixed rate of return to the institution that protects the portfolio from falling stock prices. Note, for instance, that falling stock prices generate negative payments on the variable component of the swap; that is, the institution s counterparty makes both the fixed payment promised in the swap agreement and the payment to compensate for the lost value in the underlying portfolio. Of course, this hedging strategy involves the loss of upside gains from the stock market as well part of the price paid for hedge protection. As with most swap agreements, terms of the contract can be tailored to individual needs in the marketplace. Instead of a fixed-for-variable swap, participants might elect to exchange the return on larger stocks, such as the S&P 100 index, for the return on smaller stocks, such as the Russell 2000 index. This strategy could capture the spread between large and small stock returns. Although payments commonly are arranged at quarterly intervals, contract terms can be varied to meet the cash flow objectives of each counterparty. One permutation of an equity index swap involves a single-stock swap contract wherein one party promises the return on a single firm in exchange for a fixed rate of return. These so-called single-name swaps introduce counterparty credit risk into equity investments (as do most all swap agreements). In the case of single-name swaps, however, this risk presents a significant impediment to the development of this market. For example, during the fall of 2008, when short sales were banned on many individual stocks, market participants could have skirted the ban using equity swaps. Despite the availability of these vehicles, very few took advantage of this chance, largely due to counterparty credit risk considerations. Single-name swaps also present challenges to the regulatory world that governs corporations in the United States. The SEC regulates stock trading in the United States as the investor s advocate. Single-name swaps, however, obfuscate the true ownership base of a stock. Institutions that own large blocks of the actual stock must report these holdings to the SEC. The counterparty to the single-name swap, however, currently is not required to report to regulatory authorities despite the fact that its position directly benefits from the movement in the underlying stock, just as if it had in fact purchased the stock itself. Why might this matter? one might ask. Well, the recent case of CSX Industries, a railroad operator, is illustrative. On February 7, 2008, the hedge fund TCI sent CSX a letter stating its intentions to acquire effective control of the railroad operator. Unbeknownst to CSX, TCI and other hedge funds had secretly used equity swaps to effectively take a 12.3 percent ownership stake in the railroad operator (with total direct and indirect ownership of about 20 percent of the company).

9 EQUITY DERIVATIVES 111 CSX subsequently sued these hedge funds, alleging that, by using swap contracts, they effectively evaded filing requirements that govern the disclosure of beneficial ownership of company shares under federal securities law. The SEC disagreed, however, claiming that these swaps were not sufficient to create a beneficial ownership in the firm. Financial engineering of all types, and swap agreements in particular, present challenges to U.S. legal and regulatory authorities. Securities law, written prior to the conceptual development of swaps and other derivative contracts, is evolving continually to address issues raised by complex derivatives. The growth of equity swap contracts remains robust. According to statistics provided by the Bank for International Settlements, the total notional value of equity-linked swaps and forwards exceeded $4.0 trillion in June 2008 (BIS 2008a). OTC equity-linked swaps and forward contracts alone totaled more than $2.6 trillion in notional value in June 2008, an increase of 85.8 percent from two years prior. As with most derivatives instruments, OTC equity-linked swaps and forward contracts trade in global markets with Europe taking 51 percent market share, the United States an additional 29 percent, Latin America at 5 percent, and the remainder spread between Japan and other Asian countries. Exchange-traded equity-linked swaps and forwards also exceeded $1.4 trillion in notional value in September FUTURE OF EQUITY DERIVATIVES Assets under management for global hedge funds increased to $2.650 trillion in 2007, according to HedgeFund Intelligence (2007). This represents a rise of 27 percent over the previous year. The Bank for International Settlements indicates that turnover of equity-linked exchange-traded derivatives rose by almost 33 percent in 2007 (BIS 2008b). U.S. equity options trading volume increased almost 50 percent during 2007 as well, according to the Options Clearing Corporation (the U.S.- based clearing corporation (2008). Since the credit crisis of 2008, many investment categories have seen dramatic declines in both price levels and trading volume. Notably, while liquidity in OTC-traded products has fallen drastically during 2008, exchange-traded products have seen record levels of volume and trading activity as large institutions seek the relatively safe haven of central clearing on organized exchanges. Part of the liquidity problem lies in the design of equity derivative instruments themselves. The nonlinear payoffs that are generated by options contracts, for instance, make it difficult to hedge large portfolios without regular adjustments. These regular adjustments presume adequate liquidity over the holding period of the option, exposing traders to liquidity risk not only at the time of purchase but throughout the life of the option. Further uncertainty exists even if individual assets initially are hedged appropriately because the correlations of assets within a portfolio can and do change over time. As a result, substantial correlation risk can also affect the bottom line for many banks. The worldwide spread of derivatives contracts has also presented challenges to regulators and legal authorities. The Options Industry Council survey in 2006 indicated that 15 to 20 percent of U.S. options trading volume originated from Europe, creating the need for international cooperation. The CFTC has taken a

10 112 Types of Financial Derivatives leadership role in the International Organization of Securities Commissions and has established dozens of memorandums of understanding with other countries to share expertise and data and coordinate on regulatory affairs. The SEC is similarly working on rule changes to make it easier for foreign derivatives exchanges to market their products in the United States. International cooperation is needed to keep up with the growth and popularity of U.S. equity and equity index options abroad. As electronic access drives information and monitoring costs lower, the world has become a smaller place for derivatives traders. Two major exchanges the New York Stock Exchange (NYSE)/Euronext and Eurexhave recently invested in new technology that should help to continue driving down costs. NYSE/Euronext, operating options markets in Amsterdam, Paris, London, and New York, is currently attempting to draw more European options markets to join its group. NYSE/Euronext affiliates abroad held an 11 percent market share in U.S. trading during July By comparison, the Chicago Board Options Exchanges and the electronic International Securities Exchange (ISE, the U.S. subsidiary of Eurex) held approximately 34 percent and 28 percent domestic market shares, respectively. Indeed, because of an increase in international demand for derivatives there is an increase in pressure for international mergers of exchanges. International mergers at the exchange level have created a dynamic environment for derivatives traders. As competition for trading volume increases, technological improvements facilitate the movement of positions around the globe. The growth of exchangetraded derivatives has increased partly due to credit concerns with counterparty risk in many of the OTC markets. During 2008, there was a shift toward stronger credit risk firms and toward exchange-traded equity derivatives as a direct result of the credit crisis. REFERENCES BIS (Bank for International Settlements), 2008a, 22c.pdf. BIS (Bank for International Settlements), 2008b, Burghardt, G Volume Surges Again: Global Futures and Options Trading Rises 28% in 2007, Futures Industry Magazine, March/April, Hedge Fund Intelligence, 2007, Global Review Update, Autumn, 6 7. Nybo, A Rising Institutional Demand for Equity Options, Futures Industry Magazine, May/June, Options Clearing Corporation, 2008, information index.jsp. Options Industry Council, 2006, timeline.jsp. Q&A: Nick Tranter: BNP Paribas Looks to the Future Futures and Options World, July 1, 7 8. FURTHER READING Campbell, J. Y., M. Lettau, B. G. Malkiel, and Y. Xu Have Individual Stocks Become More Volatile? An Empirical Exploration of Idiosyncratic Risk, Journal of Finance 56: 1 43.

11 EQUITY DERIVATIVES 113 DeFontnouvelle, P., R. P. H. Fishe, and J. H. Harris How New Entry in Options Markets affected Market Making and Trading Costs, Journal of Investment Management 3: ABOUT THE AUTHORS Jeffrey H. Harris is the chief economist of the U.S. Commodity Futures Trading Commission and professor of finance in the Lerner College of Business and Economics at the University of Delaware. He earned a BA in physics from the University of Iowa in 1986, an MBA from the University of Iowa in 1987, and a PhD in finance from the Ohio State University in He is the author of 10 published articles in leading peer-reviewed journals on topics related to market microstructure, initial public offerings, and derivatives markets. Dr. Harris has served as Visiting Academic Scholar at the U.S. Securities and Exchange Commission and as Visiting Academic Fellow at Nasdaq. Previously he held faculty appointments at the University of Notre Dame and the Ohio State University. He currently serves on the Program Committee for the Financial Management Association International, the Western Finance Association and the European Finance Association. L. Mick Swartz graduated with a PhD in finance from the University of Iowa in That year he taught for the University of Manitoba in Winnipeg, Canada, and taught finance in Ukraine for the Canadian government. Dr. Swartz has received many teaching awards for teaching corporate finance, investments, and derivatives (options and futures). He has over 10 refereed journal articles on corporate finance/governance and investments and over 20 presentations at finance conferences. He has been a speaker for community groups, consulted state legislators concerning executive compensation, given advice on merger legislation, and taught in Australia, the Ukraine, the United Kingdom, Canada, Poland, and Germany. Dr. Swartz has appeared on NBC and CNN as well as many radio broadcasts, discussing topics such as the financial crisis, executive pay, investment strategies, retirement planning, bailouts, derivatives, options, SWAPS, and the general economic environment.