Authored by Andrew Cross
Equity derivatives are used by a wide range of buy-side firms. For example, public companies use equity derivatives on their own shares for treasury management purposes (for example, share repurchase transactions and other stock buy-back programs). Also, investment managers and their clients use equity derivatives in pursuit of investment objectives and related strategies.
Given the unprecedented levels of market volatility, counterparties to equity derivatives should consider analyzing their trade confirmations to determine whether market events could result in:
- The termination of a particular transaction prior to its scheduled termination date; or
- An additional payment by one of the counterparties.
In addition, it is a good idea to make sure that any payment or pricing provisions that reference a particular rate (like the Fed Funds Effective Rate) will function as intended in the current low interest rate environment.
Hedging Disruptions, Increased Hedging Costs, and Market Disruptions
Equity derivatives often include contractual provisions that could require transactions to be terminated or payments to be made, due to the occurrence of certain market events. By way of example, an equity derivative entered into by a buy-side firm with a bank will often be governed by a confirmation that incorporates the 2002 ISDA Equity Derivatives Definitions. The confirmation may include provisions that would allow the bank to terminate the particular derivative, if the bank is unable to hedge its obligations in respect of the derivative. Or, the bank may be able to terminate the derivative if the bank would incur a materially increased cost to hedge the transaction (i.e., relative to the hedging costs that it would have occurred at the that the time that it entered into the particular derivative with a buy-side firm). Also, many confirmations may accelerate the termination of an equity derivative due to disruptions on the exchanges on which underlying equity securities trade (including securities that comprise an index).
Pricing Provisions in the Current Interest Rate Environment
Equity derivatives typically reference the market price of an underlying equity security and then adjust that price by reference to a particular reference rate (such as the Fed Funds Effective Rate). Counterparties should analyze their equity derivatives to ensure that any payment or pricing provisions that reference a particular rate will function as intended in the current low interest rate environment. By way of example, some equity derivatives may determine the price of an underlying equity by reference to the exchange price multiplied by a rate that references the Fed Funds Effective Rate minus a spread of a stated amount (50 bps, 75 bps, etc.). If the spread is large enough, then the pricing terms may result in negative prices, a fact pattern that may not be contemplated by the terms of the contract. It is also possible for the pricing formula to employ a formula that would multiple a share price by zero, which could result in pricing mechanisms that does not function at all.
Conclusion – Analyze Trade Confirmations
Banks that deal in equity derivatives are likely to, or soon will, conduct this sort of an analysis of their outstanding equity derivative confirmations.
However, we generally recommend that any buy-side counterparty consider doing this sort of an analysis now, in order to ensure that it understands the potential scope of any legal or business issues under its trade documentation.
This post is not legal advice. Any analysis of an equity derivative depends on the facts and circumstances of that transaction. Such an analysis should be done in consultation with qualified professionals who are familiar with the derivatives transactions.
Good day. Good to remember disruption events, especially in volatile markets. DR2