Financial Crisis Leaves Equity Derivatives Market In Flux

Dec 12 2008 | 2:08am ET

Trading volumes of highly liquid flow equity derivatives surged last year in North America as hedge funds, asset managers and other institutional investors shifted strategies in response to mounting turbulence in global equity markets. But with investors retreating to safer and better-understood instruments in the face of historic volatility, the use of structured or securitized equity products fell sharply in the last 12 months, according to a new study by Greenwich Associates.

Two-thirds of North American institutional investors surveyed by Greenwich Associates use equity derivatives as an overlay to their equity investment strategy. Sixty percent use derivatives to express directional views on individual stocks, sectors or markets; that share jumps to 83% among hedge funds. Over 40% say they employ more complex strategies that include equity derivatives as a core component.

With the spike in volatility from last summer though the second quarter of 2008 institutions ratcheted up their use of flow derivatives products. Commission payments by North American institutional investors on equity options trades soared some 50% during the period. In a shift from prior years, however, the proportion of institutions using certain flow products was flat or actually declined year-to-year, even as the volume of trading business was increasing.

In the run-up to the outbreak of the current financial crisis, the survey found that North American institutional investors were stepping up their use of structured securitized equity derivative products. As recently as 2006, only 20% to 25% of investors used these products; by 2007 that share had jumped to more than 40%. That trend reversed itself in dramatic fashion last year: Only 20% of North American institutional investors did any structured business with equity underlyings from 2007 to 2008.

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