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There is an article in the Financial Times today concerning equity funded collars [1]. The equity collar structure is used by a counterparty $A$ which wants to build up a position in a stock $S_t$. Let $B$ be the investment bank arranging the transaction, then the structure is as follows:

  • $A$ enters into an equity collar with $B$ on shares $S_t$, i.e. $B$ sells a put with strike $k$ to $A$ and buys a call with strike $(k+\varepsilon)$ from them;
  • Given the collar has positive delta to $B$ (short put + long call), to delta-hedge it the bank borrows stock $S_t$ which it then sells to $A$.

Another way for $A$ to build a position in the stock would be a margin loan, in which $A$ buys stock $S_t$ with a loan from $B$ which is collateralized by the bought stock (i.e. a repo-like transaction). Cash margin calls ensue if the stock price starts falling below predefined levels.

Now, the article claims that

[...] banks like [collars] because instead of taking on the credit risk of the borrower [as in a margin loan] , they take on the market risk of the underlying stock, which they can hedge as the share price fluctuates.

I understand the delta-hedge on the collar is imperfect (partial hedge, discrete rebalancing) plus there is gamma exposure, hence I understand the market risk coming from the collar structure (although it could be argued a margin loan also has market risk given it is collateralized by the stock). I also understand the credit/counterparty risk coming from the margin loan transaction, as a counterparty defaulting in the midst of a fast depreciation of the stock would leave the bank exposed to the gap between the latest margin call and the value of the stock collateral.

However I struggle to understand why there is no credit/counterparty risk in the collar structure. Can anybody explain?

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There is no credit risk because the client pledges the underlying shares as collateral to the funded collar. This is not explained in the article.

The structure is built in such a way that the value of the loan + derivative package is always less than the value of the shares.

This can be done by for example lending an amount equal to the discounted put strike minus the initial cost of the collar (minus bank pnl).

The counterparty credit risk disappears and the bank can concern itself solely with the risk management of the position wrt market risk factors.

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  • $\begingroup$ what loan are you referring to? $\endgroup$
    – Daneel Olivaw
    Commented Apr 19, 2018 at 9:32
  • $\begingroup$ The payoff to the client of the collar combined with the share can be written: $\Phi(S_T)=k1_{\{S_T<k\}}+S_T1_{\{k\leq S_T \leq k+\varepsilon\}}+(k+\varepsilon)1_{\{k+\varepsilon<S_T\}}$ thus it is always positive, meaning that the bank will never have positive exposure and hence any counterparty risk. $\endgroup$
    – Daneel Olivaw
    Commented Apr 19, 2018 at 9:37
  • $\begingroup$ The structure is a funded collar ie loan + collar. $\endgroup$
    – Ivan
    Commented Apr 19, 2018 at 13:52
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Further, a key element is overlooked in these answers. Although the share pledge under the collar transaction does eliminate most of the credit risk borne by the investment bank - it is still a loan. Which means that the borrower would have to pay interest, thus, exposing the investment bank to credit risk once again. This risk, however, can be eliminated by further reducing the initial loan amount to include interest payments that the borrower should be making - essential prepaying the loan. Effectively, this is the only way to fully eliminate creditors for the investment bank

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The article itself answers it:

And banks like the product because instead of taking on the credit risk of the borrower, they take on the market risk of the underlying stock, which they can hedge as the share price fluctuates. Rather than charging fees for the facilities, banks book them as trading positions on which they look to profit.

It is just really hedging the market risk of the stock so it can hedge it in the market.

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