It is very likely that derivatives history was made on October 23, when the CBOE, the Amex and the Pacific Stock Exchange traded their first equity flex options-though it may take a few years for this fact to be widely perceived, since it will take time for their uses and markets to develop. The e-flex options on 34 stocks that were created that day (see box) represent an attempt by listed exchanges to capture some of the structured equity volume that have been bread and butter to the OTC. According to Michael Schwartz of Oppenheimer, "E-flex could have a lot of appeal to users of collar techniques, who've gone off the board to do transactions that protect large low-cost stock positions of corporate insiders."

Another target group of users are portfolio managers, who today rarely consider options as part of their acquisition or sale of large blocks. According to Gary Gastineau of the Amex, a block seller who is not selling on adverse perceptions, but merely to fine-tune portfolios, could net better terms by retaining the stock and instead selling a call at close to the money for a month or two duration-perhaps till sometime after an earnings release.

The price of this option might be a little under its fair value, but would be small beer compared to the discount to market for unloading a large block. If his assumption is that there are no negatives, then the option is called away from him very near to the original market price of the underlying. "So I think you are going to see this as a very popular application with block traders," says Gastineau. "You'll see more institutions come in who've been able to ignore options in the past. There are still very few institutional users of options." He adds one caveat, however: It'll take some time for the block trading applications to be widely understood. "Once it is, though, it will be an integral part of the way institutions trade stocks," Gastineau believes.

E-flexes, like index flexes, offer customizability of such terms as expiration date, exercise style (American or European) and exercise price. Quite deliberately they have been made expensive enough to be beyond the pocketbooks of individual punters in the option market. A minimum of 250 contracts, representing 25,000 shares of the underlying, must trade in order to open an new e-flex series. And on existing flexes the trading minimum is 100 contracts. Position limits are three times those allowed in index flexes. "Obviously this is a product aimed at institutions, as well as wealthy individuals who may have significant holdings in a stock that they acquired as part of the founding group," says Bill Barclay of the CBOE.

Other likely users of e-flex include:

n Corporate stock buyback programs that include the use of OTC put sales could be attracted by position limits fatter than allowed with indexes. Many are also likely to be drawn to the price discovery features that dealers cannot offer.

n Mutual funds who've experienced a big run-up in a stock will likely want to get past the tax-advantaged three-month holding minimum by selling a European call and meanwhile buying a put-the former just above the money, the latter just below.

n Now volatility strategies can be tailored to specific events-say post-election-to the day of choice. Similarly where there is an merger deal in the works, an investor can hedge away the deal risk by setting up a specific expiration date.

n Convertible arbitrage managers tactics will be refined, thanks again to improved customizability. A frequent tactic of these investors is to hedge with listed options, usually LEAPS. (The 34 listed e-flexes all have LEAPS, too.) The disadvantage of LEAPS is that they usually don't match up with the date when a convert is callable. "If I had a convertible arbitrage account," says Leon Gross of Salomon Bros., "I'd rather flex something and get the exact strike and the exact maturity, as opposed to LEAPS which might be off by quite a bit." Gross further believes that it may be easier for some investors to get sellers on the floor, since many dealers themselves have big convert trading portfolios: "The floor might provide more liquidity because they don't have the conflict of running a convert book."

Then, too, for all categories of users there could be a great advantage in the fact that transactions are backed by the full faith and credit of the Options Clearing Corp. "All things being equal, the institutional investor has to consider that he is getting an endorsement from the OCC rather than Hubton & Rye Brokerage or a third-world bank," Schwartz notes. "The OCC's triple-A standing should be very appealing to anyone hedging risk from a corporate standpoint."

Easy buyback

''This is going to be one of the most innovative developments in options trading that we've seen in a long time," says Scott Fullman, chief options strategist for Swiss American Securities. Fullman believes that e-flex will offer a more liquid market than existed heretofore. "Say you're a writer and it comes time to buy back. You will feel better in a competitive marketplace, whereas in the OTC you can only go back to the person you originally traded with, and that's a negative. A lot of people perceive that as an opportunity to be squeezed," Fullman says.

But flex is not going to sweep the OTC market into the sea. A recent tax ruling has been something of a setback. Initially the exchanges had planned for customized strikes on both calls and puts. But at present it's not possible on the calls-the IRS says this would violate a ruling on qualified calls on regular options. Needless to say, negotiations with the IRS are bent on resolving this matter.

Position limits are yet another negative in terms of attracting institutions, which is why the Amex is spearheading talks with the SEC to get them removed altogether. "For equity flex to achieve anything like its full potential it has got to be done with no position limits," says Gastineau. "As long as there are limits, they will constrain those who believe that as they approach those limits they run the risk of being the largest or the only factor in the market. So when they see any kind of a ceiling they don't want to get involved."

The product's real test will come when e-flex will or won't trade in significant volume. Most of the midwives to the e-flex don't expect any immediate fireworks-in part because most potential users already have the next few months pretty well mapped and are unlikely to seek new positions or hedges. One factor that will be closely watched in the coming months is the most frequent maturities. Some experts doubt that the bulk of e-flexes will trade much beyond a week or two, and that precious few will go out to the maximum of three years. "Also people want to see that these things trade. Everyone wants a track record," says Fullman, "but I think eventually this is going to be one of the best products to come out of the exchanges. I'm hoping it takes off. It may even bring back institutions to the option writing game."

There is a new GARP on the block, one not born of the famous John Irving novel. This one is a grassroots organization of risk managers with the full name of Global Association of Risk Professionals. GARP is the brainchild of two individuals at dealer firms, Marc Lore and Lev Borodovsky, who with some colleagues used to meet weekly at a New York pub to talk shop-recruitment, systems, etc. Four months ago they decided to give themselves a formal name and organization that was launched on the Internet (www.chadmarc.com/garp). By early November, after a few thousand hits, GARP boasted more than 250 signed-on members from 23 countries. "It took off way beyond our wildest expectations," says Borodovsky.

GARP's mission is to enhance professionalism through sharing of information, special seminars and presentations. It will also offer an exam and a degree called the Risk Management Professional (RMP) in November 1997. "Basically we did this to help with the recruiting process. A lot of people have trouble finding a risk manager. The people who have been coming forward and saying they are risk managers are often not-they're only guys who've doctored their resumes." The RMP exam will cover quant analysis, market risk, credit risk, emerging market risk, derivatives, regulation and compliance.

Whether a framed RMP degree will ever be a ubiquitous feature of risk managers' office walls remains to be seen. But there is no doubt that it is garnering authenticity from a number of heavyweight individuals on the examination council, including John Hull, Michael Pettis, Till Guildimann and Frank Fabozzi.

GARPees don't interact only on the various Internet forums that GARP maintains; they also meet in person at lectures and seminars. Next on the agenda is a January 23 roundtable of experts on risk management, to be chaired by Charles Taylor of Andersen Consulting. "There will be very senior and very experienced people there to discuss the Bank for International Settlements recommendations, precommitment, etc.," says Borodovsky.

Many big oil companies are failing to disclose derivatives in a way that would make the Financial Accounting Standards Board happy. According to the mid-November release of Price Waterhouse's 1996 Petroleum Industry Review, among the top 30 energy giants there is but ragged adherence to the features and recommendations of Statement of Financial Accounting Standards (SFAS) 119, 107 and 105. A third of the sample confined disclosure of the face or contract value of financial derivatives to footnotes, while the rest covered the subject in both footnotes and more extensively in the Management's Discussion & Analysis (MDA) section.

Only seven of the 30 oil behemoths who held derivatives for trading purposes disclosed average fair value during the reporting period and year-end marked-to-market. Where derivatives were held or issued for nontrading motives, the reasons were footnoted by all, but discussed in the MDA by a mere 13. For anticipated transactions, 25 companies put the details in footnotes, and only three thought that candor required that they also be aired in the MDA. As for hedging gains and losses, these were relegated to the footnotes by 17 of the sample. And finally it appears that off-balance-sheet risks are still being treated cursorily: Fewer than half "disclosed the amount of accounting loss by category of financial instrument that might be incurred if the counterparty defaulted or the collateral lost value."

Price Waterhouse scrupulously avoided drawing inferences from the serious inconsistencies and noncomparability of these reporting strategies. But one can be sure that this data was noted down at the General Accounting Office (GAO), the Congressional watchdog, which coincidentally in the same week issued a follow-up to its 1994 blast at derivatives. In its 165-page report, the GAO again complained of "serious shortcomings in accounting standards [that] continue to be exposed as entities experience major losses from market-sensitive financial instruments, with seemingly little warning." Its remedy? The adoption of comprehensive market-value accounting.

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