Synthetic warrants are similar to, but distinct from, both publicly traded and OTC options. Synthetic warrants are options that trade on public markets, but they are issued by individual corporations, financial institutions or governments rather than exchaes. Consequently, as with OTC option contracts, the investor must look solely to the issuer for payment, not to an exchange or clearinghouse.
Traditionally, warrants have been issued by individual companies in conjunction with equity or debt issues; they give the investor the right to purchase additional equity or debt at specified prices at some future date and allow the company to lower its funding costs. Such traditional warrants have been particularly popular in sustained bull markets such as the U.S. experienced in the 1920s and Japan in the 1980s. Whereas companies issuing warrants can create additional shares as warrants are exercised, the issuer of synthetic warrants must have the underlying assets on hand or purchase them to deliver as demand dictates.
Broker-dealers have issued synthetic call and put warrants on individual stocks and on indexes. Among the more popular warrants were those issued on the Japanese and other foreign market indexes.
In early 1990, the Kingdom of Denmark, Salomon Brothers and Bankers Trust issued put warrants on the Nikkei index, which were listed on the Amex. These (like LOR's Celebration Fund) offered protection against decline for a portfolio of Japanese stocks, and allowed bets against the Japanese market. Although these products (especially the Nikkei puts) have been used primarily for speculative purposes, some institutions have used warrants to hedge their international portfolios.
Firms that issue such warrants may hedge themselves against market risk by using a number of trading strategies, including dynamic hedging. An April 17, 1990, Wall Street Journal article noted:
"Without these and other strategies to hedge the puts, issuers would have risked losing hundreds of millions of dollars in the recent plunge in Japanese stock prices. The put issuers execute the portfolio insurance strategy primarily by purchasing and selling Nikkei futures contracts on the Osaka and Singapore stock exchanges."
Swaps have gained huge popularity in the interest rate and currency markets. Swaps are contracts between two counterparties to exchange a series of cash flows. A simple example might be an issuer that swaps the fixed-rate interest payments on a new bond issue for floating-rate payments, or dollar-denominated bonds for bonds in other currencies. With equity swaps, one or both of the flows are linked to the performance of an established equity index or basket of stocks. The investor generally exchanges a fixed or floating interest rate for the dividend and capital appreciation on the stock index. An investor with a stock portfolio, however, can overlay it with an equity swap, paying out the dividends and any capital gains on the stocks in exchange for receipt of a fixed rate of return.
Bankers Trust initiated the first reported equity swap in 1989. Swaps are now a booming business and, to some observers, a potentially destabilizing one.
Gerald Corrigan (in the New York Times, Feb. 9, 1992), for example, has suggested "some of the specific purposes for which swaps are now being used might be quite at odds with an appropriately conservative view of a swap, thereby introducing new elements of risk or distortion into the marketplace."
An example of a less-than-conservative use of swaps might be a corporate investor that gains equity exposure by investing in a fixed-income instrument and then swapping the returns for those from a stock market index. In such an exchange, the note enters the corporate balance sheet as an asset, but the swap does not have to be reported on the balance sheet, hence does not appear as a liability.
Furthermore, a dealer engaged in a swap probably will want to hedge any market exposure incurred. This may be done by undertaking a matching swap with another counterparty. But if such an opportunity is unavailable, the dealer may engage in a dynamic hedging strategy in order to lay off its market exposure.
In the spring of 1993, Citibank began marketing a "stock index insured account," primarily aimed at retail investors. The account offers: "Stock market returns. Zero risk to principal." Citibank promised returns on a five-year deposit of twice the average monthly increase in the S&P 500 index.
Deposit and debt instruments with embedded options, or "embeddos", (also called bond-call structures or market index notes) offer insurance of principal with an option sweetener. The coupons and/or final principal payments of these products are linked to U.S. and foreign equity, fixed-income or commodity indexes. In effect, the investor is buying a bond or CD with a call option on a given index.
Embeddos offer investors participation in equity returns with a bond-like risk level. Investors proscribed from holding equities, or from holding more than a certain amount of equities, may constitute the most natural clients for these instruments. With their potential to protect principal while allowing participation in market gains, embeddos also may appeal to the portfolio insurance clientele.
Issuing banks hedge the risk of an excessive market rise by purchasing protection from other financial intermediaries in the form of OTC index options. The option writers in turn presumably hedge, perhaps with a dynamic strategy. Embeddo-like instruments had stopped being widely marketed right after the 1987 crash, because issuers had lost so much money on their risk management transactions during the crash.
The 1987 crash demonstrated that synthetic portfolio insurance does not work in the face of market illiquidity and price discontinuities and, further, that it actually can destabilize markets, making a collapse more likely. A number of instruments and approaches developed since the crash aim to sidestep the pitfalls of synthetic portfolio insurance while meeting investors' demands for portfolio protection.
Sunshine trading supposedly would encourage liquidity and reduce problems of information aggregation by providing an arena in which portfolio insurers pre-announce their trading intentions. New option and option-like instruments traded on the public exchanges may go even further toward reducing potential market instability and increasing assurance of portfolio protection. LEAPS and FLEX options, for example, offer the guarantee of the exchange clearinghouse, plus full price transparency.
OTC options offer more flexibility for insurers than even the newer exchange-traded options, but because these instruments are privately negotiated contracts, there is no clearinghouse to guarantee them. Furthermore, although an insurer that buys an OTC put will not have to sell into a falling market (or buy into a rising market) to establish the desired level of protection, the broker-dealer or other financial intermediary that has issued the option might have to engage in such dynamic trading in order to hedge the exposures it has taken on. As with synthetic insurance, the extent of such trading will not be revealed to the market. (contd. in Part 3)