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Protecting Appreciated Equity Values

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Protecting Appreciated Equity Values VOLUME NO. 11 PROTECTING APPRECIATED EQUITY THE CHALLENGE VALUES For many individuals, finding a way For owners of concentrated investments in liquid publicly traded securities, the recent to protect the value of a concentrated sharp increase in equity market volatility (see chart below) has generated considerable equity holding is likely to be one of interest in techniques for controlling market risk. While selling large single stock the most critical financial decisions holdings is an obvious solution to the problem, outright sale has limited appeal to they ever make. Fortunately, there investors for whom maintenance of control or restrictions on sale is an issue. For others, are a variety of tools and strategies the tax implications of selling significantly appreciated shares create a barrier to action. available to assist in managing However, even after the implementation of the U.S. Tax Reform Act 1997, certain tax equity price risk. This issue of efficient market risk mitigation tools have survived. Derivations describes several of the most valuable of these. Equity Floors The simplest of these market risk mitigation tools is the equity floor (or put option). A floor establishes a minimum value for a target stock, stock portfolio, or stock index. If at the hedge’s maturity (which can be as far forward as five years or more) the price of the hedged stock is below the floor price, the investor is paid the difference between the floor price and the actual market price. Equity Collars Because stock prices can be extremely volatile, the cost of long-term equity floors can be significant. For this reason, most hedgers prefer equity collars, which can be put in place for a low premium or for no premium at all. A collar establishes a floor on the stock’s value, then offsets all or most of the cost of the floor by setting a cap (a call option) on future price appreciation. At the collar’s maturity the investor receives a payment if the hedged stock’s market value is below the floor price. On the other hand, if the price of the hedged stock is above the cap strike, the investor makes a payment to cover the difference between the actual market price and the cap price. Depending on the specific stock hedged, it is not unusual to be able to construct an equity collar that provides a disproportionate amount of downside protection for the amount of appreciation the hedger must sacrifice. Hedged Stock Loans Many investors extract liquidity from stock investments by borrowing against them. Because the value of stock collateral can fluctuate considerably, most lenders are reluctant to make advances on a high loan-to-value basis. Moreover, even a small movement in a stock’s value can trigger a call for additional collateral. Hedged stock loans provide a way around these disadvantages. By hedging the price of the stock used as collateral for the term of the loan (usually with an equity collar), and posting the hedge as part of the collateral package, borrowers can achieve higher loan- to-value ratios. The hedge also eliminates the risk that a decline in the stock’s value will require the borrower to post additional collateral. Finally, the increased security the stock hedge provides the lender can sometimes translate into more favorable borrowing rates. In the example below, the investor/borrower was able to raise U.S. $ 5 million, using as collateral 123,457 hedged shares of a U.S. $50 stock. The hedge took the form of an equity collar. The collar floor was set at 90% of current market or U.S. $45, against which the lender was prepared to advance an amount equal to 90% of the floor strike price. An equity cap was incorporated to eliminate premium expense, with the cap price Hedged Stock Loan Example Loan: Loan Amount: U.S. $5 million Loan to Value: 90% of minimum hedged stock value Term: 5 years Number of Shares Pledged: ($5,000,000/$45 per share/90%) 123, 457 Equity Value Hedge: Current Stock Price: U.S. $50 Stock Price Floor: (90% of current market) U.S. $45 Stock Price Cap: U.S. $65 (130 % of current market) Hedge Cost: No premium cost Number of Shares Hedged: 123,457 struck at 130% of current market value. In this instance (which is not uncommon) the investor/borrower was able to retain significant appreciation benefits while at the same time achieving a high level of price protection for the pledged shares. Hedging Stock Options and Stock Appreciation Rights (SAR’s) Grants of stock options and stock appreciation rights have become increasingly popular and important elements in key employee compensation programs. For executives and key professionals of rising companies in rapidly growing industries, stock options can easily come to be the single most valuable asset they own. Because many programs have vesting requirements, however, appreciated options can often be as illiquid as they are valuable. In such situations equity collars are often used to protect the option owner from a significant fall in the value of the underlying stock and reduction in the options’ value. The collar is set to mature beyond the options’ vesting date. At maturity of the hedge, if the value of the stock has fallen below the collar’s floor price, a compensating payment is made to the hedger whether or not the option is exercised. If the stock price has risen above the collar’s cap strike price, the option grant is exercised and a portion of the cash proceeds from exercise is used to fund the collar payment. SUMMING UP Protecting the value of equity investments against sharp market declines need not be a complex risk management problem. Standard derivative tools such as floors and collars provide the building blocks from which effective short and long-term equity hedging strategies can be constructed. Hedges can be designed to protect individual stocks and stock options, stock portfolios or stock indices. Hedges can also be used in combination with bank loans to provide investors with enhanced liquidity. This material is for general information purposes only and is not to be relied on as investment advice. Readers should consult their own financial advisors before making any investment decisions. © Copyright Bank of Montreal 1998.
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