How Hedges Work

Executives who own big chunks of their company's stock often hedge their holdings to diversify and limit risk if the stock tumbles. Critics worry such transactions weaken the incentives created by equity compensation. They also warn that executives may use privileged information to hedge their shares ahead of bad news. Here are how the two most common hedging strategies work.

SCENARIO ONE: ZERO-COST COLLARS

This hedge puts a "collar," i.e., a floor and ceiling, around the price an executive gets paid for stock

1. An executive wants to protect 2 million shares, currently worth $100 each, against a big drop in the stock.

2. He buys a put option on the stock from a broker, which gives him the right to sell his shares at a given price, say $95. If the stock drops below $95, he sells at that price and suffers no further losses.

3. To pay for the put, the executive simultaneously has his broker sell a call option on his stock. The call gives a buyer the right to acquire the shares at a set price if they rise, say to 110.

4. If the stock goes above $110 while the call option is in effect, the executive must sell his shares to the buyer; if the shares remain between $95 and $110 during the life of the two options, he holds on to all his stock. And during the life of the collar, he can borrow funds—generally up to 50% of the value of his shares.

SCENARIO TWO: PREPAID VARIABLE FORWARD CONTRACT (PVF)

This is the more popular—and complex—hedge strategy.

A PVF sale revolves around a contract established between a senior executive and an investment bank, and it frees up more cash without initially requiring that the executive sell his stock or pay capital-gains tax.

1. Now the executive hedges those 2 million shares worth $100 apiece with a three-year PVF. He agrees on a floor and a ceiling price with the bank—again, say $95 and $110.

2. In the meantime, to protect itself from a loss if the shares fall below $95, the investment bank will generally short the company's shares. It also collects fees on the contract.

3. At the end of three years, if the shares fall below $95, the executive simply turns over his 2 million shares. He keeps the cash he received in advance and has limited his downside.

4. If, on the other hand, the shares have risen, he can settle up with the bank in cash. He hangs onto the shares and profits from any further rise in the stock.

5. Or he can pay the bank back in stock; the exact number of shares will depend on how the stock performs. The better the stock does during the life of the hedge, the fewer shares he'll owe.

6. The executive receives a cash advance from the bank that generally equals up to 85% of the value of his stock at the time of the hedge, or in this case, $170 million.

Data: Twenty-First Securities, Bloomberg BusinessWeek

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