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How Derivatives Are Changing Private Banking

How Derivatives Are Changing Private Banking

Peter Ham

Private banking is continuing to change dramatically in response to the evolving needs of the rapidly growing entrepreneurial wealth segment. The Merrill Lynch/Gemini Consulting World Wealth Report concluded that worldwide, the financial assets of individuals holding US$1 million or more grew by 18% in 1999; the report also estimates that the number of Latin high net worth individuals holding liquid financial assets in excess of $1 million will grow 12% per annum over the next five years. In the past, the primary product of many private banks was secrecy and an element of service. Today, clients of wealth are increasingly expecting much better advice and solutions to complex financial problems. An ability to understand and deliver to these clients what have traditionally been perceived as institutional capabilities characterizes today’s most sought after private bankers.

Today’s newly created wealth is most often stock based and concentrated in one or two concentrated equity positions; these positions may often be — for legal, tax, regulatory or corporate purposes — unsaleable and are the result of disclosed quasi-public ownership transactions. Holders of such securities are anxious to hedge, diversify or monetize a part of this wealth without creating a taxable or sale event. Successful private bankers have learned to address these needs by applying risk management skills from the derivatives business.

A client holding a concentrated equity position enters into a hedging transaction that protects the value of their position. This is typically achieved by entering into a “zero premium collar” or one of its increasingly many variants: The client effectively pays for downside protection by surrendering upside potential above a certain level. The cost of the put option and the premium received for the call cancel each other out, thereby requiring “zero premium” from the client to establish.

Once clients have protected the value of their positions, they have collateral that has a minimum known value and is therefore highly valuable. From a risk management perspective, the client has taken a risky position and substantially reduced the risk. Once the hedge is in place, the client can consider borrowing money, monetizing the position or expanding the risk profile back out again into a more diversified portfolio.

The precise form of the hedge used in a monetization trade depends on the regulatory and tax regimes of the client’s home country. Hedging solutions may be highly customized for individual clients to provide for specific loan and diversification needs. However, limiting factors include the liquidity of the stock, the amount of stock available to borrow (allowing the executing firm to hedge itself) and ownership covenants prohibiting pledging of the shares by the holder.

While these trades have become relatively common on US listed stocks and ADRs, the competitive front line of the hedging market is now being fought on the ability to provide protection on good quality securities in non-US markets including Argentina, Brazil and Mexico. Derivatives are very appropriate today to the problem of diversifying or hedging concentrated positions. So the more widespread internationally and the greater the number of wealth concentrations become, the more applicable and available these products will be in key equity capital markets worldwide.

Peter Ham is a director of Merrill Lynch Private Wealth Services. Private Wealth Services focuses on the unique needs of Merrill Lynch’s most substantial clients by drawing on the resources of the firm’s global investment banking, capital markets, research and money management capabilities to create tailored solutions.

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