The Variable Prepaid Forward

The variable prepaid forward is similar to the monetized collar in that it offers the investor a downside floor and an upside ceiling. It differs in that instead of borrowing money, an institutional counterparty buys the investor's stock, which will be delivered some time in the future. Depending on the nature of the stock and current market conditions, the discounted payment could be as high as 80% or 90% of current stock value. At the end of the term, the client must deliver the stock or a cash equivalent to close out the sale.

The advantage of the variable prepaid forward is that more cash is available to reinvest and diversify the portfolio than could be raised by borrowing on the collar. And if the stock performs well, less stock is needed to close out the transaction than when stock is called away as part of a collar. The more the price of the stock appreciates, the fewer shares will actually be transferred to the counterparty. On the other hand, if the price of the stock were to drop, more shares would have to be delivered. But, like a collar, there is a floor and a ceiling built into the contract.

The institutional counterparty will enter into its own hedging strategy to protect itself in the variable prepaid forward. To do this, it will sell short some of the same stock underlying the variable prepaid forward transaction. The counterparty can borrow stock from the client or from the marketplace. Borrowing from the latter is obviously more expensive and would be reflected in the price of the forward contract. Recently, the IRS issued a technical advice memorandum opining that borrowing the client's shares was the same as a constructive sale and taxes should be recognized immediately rather than deferred to the end of the term.

Like the collar, the holding period time clock is paused as the investor waits to qualify for long-term capital gain treatment. And again, you must have held the stock for more than one year before you can enter into the hedging strategy.

The cost of the variable prepaid forward is the spread between the value of the securities and the amount of the advanced payment. The spread will reflect a discount rate plus the risk that the counterparty assumes by setting a floor and a ceiling. A higher floor translates into more protection for the client, and a higher ceiling translates into more opportunity to participate in the stock's appreciation. The higher the floor and the higher the ceiling, the lower the cash advance. Plus, there are the fees for outside legal and tax advice.

Is it worth it? Both the equity collar and variable prepaid forward transactions should be seen as short-term solutions. Typically, the performance of the underlying stock and the reinvested portfolio must be higher than the borrowing or transaction costs of the hedging strategy.

Hedging Stock Options

Invariably, an executive will ask if there is a way to protect employee stock options before or shortly after they are exercised. You cannot hedge incentive stock options before exercise. Plus, using options during the year after exercise may be a disqualifying disposition and trigger ordinary income taxes. Whether a variable prepaid forward can avoid the same fate is unclear.

It may be possible to hedge the nonqualified stock option. A simple way to hedge the underlying stock is to buy a put for the same price as the option's exercise price. At the same time, the executive sells a call option at a price slightly higher than the current price. To prevent being snagged by the constructive sale rules, the spread between the put and the call is usually 20% of their strike prices.