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THE SUPPLY
Seeing an opportunity, the investment banks stepped in and provided the bridge
between investors and derivatives markets. The investment banks were able to
package the derivatives into products (OTC options) customised for individual
clients, who were unable immediately to check the price of the offered product.
Every time the client learnt the derivative skills necessary to value a particular
product, the investment bank would add another layer of complexity (e.g. an index
put option with a knockout level).
So, in effect, the investors were paying the investment banks an unknown amount to invest on their behalf in the readily available derivative markets. As investors learn more about derivatives, and start trading directly themselves, investment banks will have to look elsewhere to maintain their fat margins of the 1980's.
Of course, there were other associated influences driving the development of OTC options. One of the most important was the global diversification of equity portfolios. This provided investment banks with many opportunities to customise packages that altered the currency exposure, liquidity problems or legal constraints of overseas investment.
The mechanics of the investment bank-created OTC option are quite straight- forward. In the early days, deals would have been as simple as buying one option from a client in one market and selling the same option (i.e. an option with identical terms) in another market. Then, as competition increased, it became necessary to mismatch deals - where the option sold differed in some respect (e.g. strike level, currency) from the bought option. This introduced an element called residual risk, which might be managed in the public traded futures markets.
The diagram represents this schematically.
Volatility will be bought into the book in the form of an OTC option - which will frequently be embedded in a finance package. On the other side of the book, volatility will be sold (with a spread being taken) as an OTC option either in a private placement, or possibly a public warrant issue. The risk management of the book is concerned with controlling the net volatility exposure. This net exposure can be called the residual risk, which will be managed in the exchange traded futures and options markets.
The extent to which the the risk book will hedge with OTC options (setting up "matched deals"), or use the derivative exchanges will depend on -
Among the first OTC equity options were SWF denominated warrants on Japanese companies issued by investment houses. The issues were arranged by buying US$ denominated warrants, and reissuing them as Swiss Franc denominated. Despite the illusion that investors may have had - that they were buying SWF assets - the issues remained, yen assets.
These transactions were very easy to arrange, being matched deals. The more complex types of transaction, began in earnest in the public warrant market with the issue of cash-settled warrants linked to the Nikkei Index.
Following this, the OTC derivative market became very active with warrants being issued that were linked to stock indices, individual stocks, currencies, and bonds.
Many OTC options are called covered warrants; the implication being that the security of the issue is somehow assured by the issuer holding a position in an underlying asset. Possibly, investors are comforted with the belief that something tangible exists behind a rather abstract instrument.
However,
In effect, it matters little to the investor whether an issue is fully covered or not. The investor takes the credit risk of the issuer alone, and although the parent company may be a world-wide name, if the crunch came the investor would have to be happy that Acme Global Bank would stand by its Caribbean registered subsidiary.
In the past a distinction between exchange-traded and non exchange traded instruments was made in an attempt of categorisation. Investors felt more comfortable trading the former, in the belief that the exchange conferred liquidity and security - through the satisfaction of the exchange listing requirements.
However, competition between exchanges is fierce. In an effort to grab a slice of the action in the exciting new world of derivatives , some exchanges have been relaxing listing rules.
The development of the Eurobond market encouraged the growth of exchanges such as that in Luxembourg, where "listings of convenience" could be arranged - with little liquidity or security being offered.
In the last few years a number of warrants have been listed, for example, on the American Stock Exchange. These were associated with stock indices or currencies, and would classically be defined as OTC options, but they are now listed and traded on an exchange. These warrants had to satisfy the listing requirements of the Exchange.
However, it is difficult for the listing rules to keep pace with the development of new financial instruments. In a 1990 Kingdom Of Denmark Nikkei-linked warrant issue, the prospectus usefully informs potential investors that,
"...the density of Denmark's population, 308 inhabitants per square metre, is substantially greater than that of Norway or Sweden, but considerably less than that of the United Kingdom or the Federal Republic Of Germany...",
Which is very interesting to learn, but not necessarily of key importance when assessing the investment potential of the warrant.
It is important not to confuse OTC options listed on exchanges, with exchange- traded options. In the case of the former, the exchange offers no guarantee (unlike exchange-traded options), the sole credit risk is the issuer of the warrants
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