Equity derivatives are financial instruments whose value relates to fluctuations in the underlying value of one or more equity securities. They are complex financial instruments that allow participants to hedge existing equity positions or profit from movements in underlying equity securities.

Some common types of over-the-counter (OTC) equity derivative products and transactions include convertible notes, bond hedges, accelerated share repurchases (ASRs), reverse ASRs, capped calls, bifurcated call spreads, convertible preferred stock, structured margin loans, put and call pairs, and registered forwards.

Equity derivatives are commonly used for hedging. Hedging allows participants to reduce their risk exposure and can mitigate potential losses. Many equity derivative transactions involve borrowing a security from a relatively liquid market in order to hedge exposure.

When a company issues convertible bonds, they may utilize capped calls to hedge against potential dilution when the bonds convert into equity. Capped calls are a type of call option that can have the effect of increasing the conversion rate of the bonds. First, the company will purchase a call option on the company’s own stock. This call option will have an exercise price equal to the conversion price of the bonds. The company will then sell the call option to a bank at a higher exercise price. Thus, capped call products can protect existing shareholders from dilution.

A company may execute an accelerated share repurchase (ASR) through a forward contract. Accelerated share repurchase products enable a company to buyback its own shares on an accelerated basis. A reverse ASR can be used by a company to facilitate the disposition of its shares on an accelerated basis. Both types of ASR transactions are conducted by investment banks.

The International Swaps and Derivatives Association (ISDA) has published the ISDA master agreement, which is a standard agreement covering many types of OTC equity derivative transactions. Its goal is to establish consistent documentation that can be used by parties in many jurisdictions.

The first part of the ISDA master agreement contains the standardized terms. This includes standardized obligations, representations, undertakings, events of default, termination events, transfer, and remedies provisions. There is also a section with standardized definitions for certain terms such as “Affected Party,” “Defaulting Party,” and “Early Termination Date.”

The second part of the ISDA master agreement has a schedule that allows for customized terms. In the schedule, the parties can lay out modifications to the provisions of the ISDA master agreement and add bespoke provisions. For example, the parties can modify the tax representations or termination provisions to be tailored to the parties’ negotiated preferences.

Companies, dealers, and other participants utilizing equity derivatives products should have an understanding of the legal regimes applicable to such products. Equity derivative transactions are generally regulated by the Commodities Futures Trading Commission (CFTC). Certain security-based swaps are regulated by the Securities and Exchange Commission (SEC).

The Commodity Exchange Act and the rules promulgated by the CFTC establish many reporting requirements for derivatives transactions. One counterparty to the transaction, typically the dealer, is required to report the primary economic term of certain derivatives transactions to a swap data repository (SDR).

In addition, many equity derivative transactions must comply with the anti-fraud provisions under Section 10(b) of the Securities Exchange Act of 1934 (Exchange Act) and the anti-manipulation provisions of Regulation M under the Exchange Act.