8.1 Types of derivatives

Derivatives play a crucial role in mergers and acquisitions, offering tools to manage risks and structure complex deals. From forwards and futures to swaps and options, these financial instruments allow companies to hedge exposures, speculate on price movements, and create tailored solutions for M&A transactions.

Understanding the various types of derivatives is essential for M&A practitioners. Each instrument has unique characteristics and applications, from standardized exchange-traded contracts to customized over-the-counter agreements. Proper use of derivatives can help optimize deal structures and manage financial risks throughout the M&A process.

Types of derivatives

• Derivatives are financial instruments whose value is derived from an underlying asset, such as stocks, bonds, commodities, currencies, interest rates or market indexes
• Derivatives allow companies to manage financial risks, speculate on price movements, and structure complex transactions in mergers and acquisitions
• Common types of derivatives include forwards, futures, swaps, options and various exotic structures, each with unique characteristics and applications in accounting for M&A deals

Forward contracts

Long positions in forwards

• Buying a forward contract gives the holder the right and obligation to purchase the underlying asset at a predetermined price on a specific future date
• Long positions benefit from price appreciation of the underlying asset, as the forward contract allows buying at the lower, locked-in price
• Example: A company entering into a forward contract to buy foreign currency needed for a future acquisition, thereby hedging against exchange rate fluctuations

Short positions in forwards

• Selling a forward contract obligates the holder to deliver the underlying asset at the agreed-upon price on the settlement date
• Short positions profit from price declines in the underlying asset, as the contract allows selling at the higher, predetermined price
• Shorting forwards can hedge against potential losses on assets the holder already owns (wheat producer locking in sales price)

Hedging with forwards

• Forward contracts commonly hedge exposure to price, interest rate or currency risks by locking in future transaction terms
• Hedging with forwards reduces uncertainty and protects against adverse market movements that could impact M&A deal financials
• Commodity producers (oil companies), exporters, and companies with foreign subsidiaries often use forwards to manage their risk exposures

Speculation with forwards

• Speculators use forward contracts to bet on the future direction of asset prices without owning the underlying asset itself
• Speculative trades provide market liquidity but can also amplify risks if positions are highly leveraged or concentrated
• M&A deal counterparties must be aware of the potential impact of speculative derivative positions on deal valuations and risk assessments

Futures contracts

Futures vs forwards

• Futures are standardized contracts traded on exchanges, while forwards are customized agreements negotiated privately between counterparties
• Futures have set contract sizes, expiration dates, and settlement procedures determined by the exchange
• Futures require daily margin settlement, whereas forwards typically settle only at maturity, creating different credit risk profiles

Margin requirements

• Futures traders must post initial margin (good faith deposit) and maintain variation margin to cover daily price fluctuations
• Margin requirements limit counterparty credit risk but may also force position liquidation if margin calls cannot be met
• M&A dealmakers should assess potential margin funding needs and impacts on liquidity when using futures for hedging or speculation

Clearing house role

• Futures exchanges use clearing houses to act as central counterparty to all trades, reducing default risk
• Clearing houses set margin requirements, process daily settlements, and guarantee trades, promoting market stability and integrity
• Centralized clearing can mitigate counterparty risks for M&A transactions but may concentrate systemic risks

Standardized contract terms

• Standardization of futures contract terms enhances liquidity and price transparency compared to customized forward agreements
• Standard terms include asset type, quantity, quality, delivery location and date, allowing efficient trading and easier offsetting of positions
• M&A deal structures may favor more customized derivatives for precise risk management, while standardized futures suit hedging of more generic exposures

Swaps

Interest rate swaps

• Interest rate swaps involve exchanging floating rate payments for fixed rate payments or vice versa, based on a notional principal amount
• Companies use interest rate swaps to transform interest rate exposures and optimize capital structure (floating to fixed to lock in rates)
• In M&A, swaps can hedge interest rate risks on deal financing or align interest rate characteristics of merging entities

Currency swaps

• Currency swaps entail exchanging principal and interest payments in one currency for those in another currency
• Firms use currency swaps to access foreign capital markets or hedge long-term foreign currency exposures at favorable rates
• Cross-border M&A transactions may employ currency swaps to fund deals or manage post-merger foreign exchange risks

Credit default swaps

• Credit default swaps (CDS) transfer credit risk by having one party pay a premium to another who agrees to compensate credit losses on a reference debt
• CDS act as insurance against default or credit rating downgrades, allowing credit risk transfer and portfolio diversification
• In M&A, CDS can hedge credit exposures or be used to structure contingent payments based on credit events

Swap valuation

• Swap pricing involves calculating the present value of expected future cash flows based on forecasted interest rates, exchange rates or credit spreads
• Valuation models incorporate discount rates to reflect time value of money and counterparty credit risk
• Swap valuations are important for M&A accounting, risk management and determining fair value of contingent deal considerations

Options

Call options

• Call options grant the buyer the right, without obligation, to purchase the underlying asset at a set strike price before expiration
• Calls have unlimited profit potential if prices rise, with losses limited to the upfront option premium
• M&A dealmakers can use call options to secure the right to buy a target company's shares at an agreed price

Put options

• Put options give the holder the right to sell the underlying asset at the strike price, providing insurance against price declines
• Puts increase in value as the underlying asset price falls, offering a floor on potential losses
• Puts can hedge downside risk in M&A transactions or be used in negotiating deal terms and break-up fees

Option payoff diagrams

• Option payoff diagrams visually represent the profit or loss on an option at expiration for different underlying asset prices
• For a long call, profits accrue above the strike price, while long puts generate profits below the strike
• Understanding option payoffs is crucial for structuring risk management strategies and valuing embedded options in M&A deals

Factors affecting option prices

• Option prices depend on several variables, including the underlying price, strike price, time to expiration, volatility, interest rates and dividends
• Higher underlying price, longer expiration, greater volatility and higher interest rates increase call values, while dividends decrease them
• Option pricing models like Black-Scholes use these inputs to estimate fair values, which may be needed for M&A purchase price allocations

Option strategies

• Options can be combined in various ways to create strategies with specific payoff patterns and risk profiles
• Common strategies include covered calls, protective puts, spreads, straddles and collars, each suitable for different market outlooks
• M&A practitioners may employ option strategies to manage deal risks, structure earn-outs or hedge exposures during transactions

Exotic derivatives

Barrier options

• Barrier options are path-dependent exotics that either become activated (knock-in) or expire worthless (knock-out) if the underlying price reaches a preset barrier level
• Barriers can be set above or below the initial underlying price and monitored continuously or at expiration
• Barrier options offer customized risk management solutions and can be embedded in M&A deal terms to create contingent payouts

Asian options

• Asian options have payoffs determined by the average underlying price over a specified period, rather than the price at expiration
• Averaging reduces the impact of short-term price volatility, making Asians cheaper than standard options
• Asian options may be useful for hedging recurring exposures or structuring earn-out provisions in M&A based on average performance metrics

Basket options

• Basket options are written on a portfolio of underlying assets, with payoffs tied to the overall performance of the basket
• Baskets can include various asset classes (stocks, currencies, commodities) and may be equally or custom weighted
• In M&A, basket options can hedge risks or define payouts linked to the combined performance of merged entities or multiple deal factors

Other exotic structures

• Exotic derivatives encompass a wide range of bespoke structures, such as look-back options, chooser options, compound options and quanto options
• Exotics are tailored to specific risk profiles, market views or hedging needs, often combining features of multiple option types
• M&A dealmakers may use exotics to create unique risk-sharing arrangements, contingent payments or to monetize complex exposures

Derivative markets

Exchange-traded derivatives

• Exchange-traded derivatives include standardized futures and options contracts listed on regulated exchanges like the Chicago Mercantile Exchange (CME)
• Exchanges facilitate price discovery, provide transparency and reduce counterparty risk through centralized clearing and margin requirements
• M&A participants may use exchange-traded derivatives for more liquid, generic hedging needs or to gain market exposure

Over-the-counter derivatives

• Over-the-counter (OTC) derivatives are privately negotiated contracts between counterparties, including forwards, swaps and exotic options
• OTC markets offer flexibility to customize contract terms, sizes and settlement provisions to suit specific risk management needs
• M&A transactions often involve OTC derivatives to address unique deal risks, structure contingent payments or bridge valuation gaps

Derivative market participants

• Derivative market participants include hedgers (corporates, institutions), speculators (hedge funds, traders), arbitrageurs and financial intermediaries (banks, brokers)
• Hedgers use derivatives to manage risks, speculators aim to profit from price movements, arbitrageurs exploit mispricing, and intermediaries facilitate transactions
• M&A dealmakers must navigate the complex interactions and motivations of different market participants when using derivatives in transactions

Derivative market regulations

• Derivative markets are subject to regulations aimed at promoting transparency, stability and integrity, such as reporting and clearing requirements
• Key regulations include Dodd-Frank in the US, EMIR and MiFID II in Europe, and local rules in other jurisdictions
• M&A practitioners must ensure compliance with derivative regulations, which may impact deal structuring, valuation and risk management strategies

Derivative pricing models

Black-Scholes model

• The Black-Scholes model is a widely used formula for pricing European-style options based on key inputs like underlying price, strike, time to expiration, volatility and risk-free rate
• The model assumes log-normally distributed returns, constant volatility and no early exercise, dividends or transaction costs
• In M&A, Black-Scholes can value embedded options, estimate fair values for contingent payments and guide risk management decisions

Binomial option pricing

• Binomial option pricing models use discrete-time, binomial trees to model the evolution of the underlying asset price and value American-style options
• Binomial trees involve price moving up or down by set factors in each time step, with option values calculated recursively from expiration to the present
• Binomial models offer more flexibility than Black-Scholes, accommodating early exercise, dividends and varying volatility, which may better suit certain M&A situations

Monte Carlo simulation

• Monte Carlo simulation is a numerical method for pricing derivatives by simulating thousands of possible price paths for the underlying asset
• The approach is useful for complex, path-dependent exotics or options with multiple underlying assets, where analytical solutions are unavailable
• M&A valuation and risk analysis may employ Monte Carlo to model the distribution of deal outcomes and value contingent payouts

Limitations of pricing models

• Derivative pricing models rely on simplifying assumptions that may not hold in reality, such as constant volatility, normal returns and perfect markets
• Models are sensitive to input assumptions, and small changes can lead to large differences in estimated values
• M&A practitioners should understand model limitations, use multiple approaches, stress-test assumptions and apply valuation adjustments as needed

Derivatives in M&A

Risk management applications

• Derivatives help manage various risks in M&A transactions, such as price, interest rate, currency and counterparty risks
• Hedging strategies can lock in asset values, financing costs and exchange rates, reducing uncertainty and exposure to adverse market moves
• Derivatives also facilitate risk transfer and sharing between deal parties, enabling more flexible transaction structures

Contingent consideration structures

• Contingent consideration (earn-outs) in M&A can be structured using derivatives like options, forwards or swaps
• Derivative-based earn-outs tie payouts to future performance metrics, stock prices or other variables, aligning incentives and bridging valuation gaps
• Designing and valuing contingent structures requires careful analysis of derivative pricing models, payoff patterns and accounting implications

Hedging deal exposures

• M&A transactions often create exposures to interest rate, currency and commodity price risks that can be hedged with derivatives
• Pre-deal hedging can lock in acquisition costs, while post-merger hedging can protect expected synergies and cash flows
• Hedge accounting rules must be navigated to avoid earnings volatility and ensure appropriate financial reporting

Post-merger integration considerations

• Derivatives used in M&A transactions require ongoing management and integration into the combined entity's risk management framework
• Valuation, reporting and control processes must be aligned, and potential impacts on liquidity, credit risk and regulatory compliance addressed
• Effective integration of derivatives supports realizing deal synergies and ensures proper risk governance in the post-merger organization