Equity Swap
1. Learning Objectives
- Learn the three main components of
an equity swaps
- Identify other unique qualities of
an equity swap
- Explain why an investor would
trade equity swaps
2. Content
An equity swap is an OTC derivative where
there is an exchange or “swap” of cash flows between two parties. One cash flow
is the equity performance of a regularly traded stock. The other cash flow is
interest. As with most derivatives, cash moves ONLY at the closing of the
contract when a SALE
2.1. Three
P/L Components of an Equity Swap
There
are three components to include in your calculation of P/L on an equity swap:
2.1.1.
Equity Leg
This
represents the performance of the underlying stock.
2.1.2.
Interest Leg or Financing Leg
This
represents the amount of interest that the “long” side of the contract must pay
to the “short” side in exchange for receiving the equity appreciation in
the stock’s performance. This is why the “long” side is referred to as the “floating
rate payer” on the swap contract documents.
2.1.3.
Dividend Leg
When
entering into an equity swap, all rights and obligations of the underlying
stock with regard to the corporate actions still apply. Therefore the “long”
side of the contract receives any applicable dividends. Since the shares
are not actually purchased on an exchange, the company itself does NOT pay the
dividend. Instead the “short” side of the contract must pay any
dividends declared by the company to the “long” side of the contract.
2.2. Other
Terms of an Equity Swap
2.2.1.
Notional
An
equity swap contract does not have an actual cost associated with the trade. No
cash is involved when entering into an equity swap. There is an “underlying”
cost which is the quantity X price. This “underlying cost” is referred to as
the “notional” amount. This notional amount is used to calculate the interest
component of an equity swap. It is the principal amount on which the interest
is calculated.
2.2.2.
Resets
An
equity swap contract has a typical duration of three months. However the
participants of the swap do not wait for three months to exchange cash flows.
The swap contract has a pre-determined schedule of cash flow dates during the
three month term of the contract. This schedule is referred to as “reset dates”.
Resets may occur weekly or monthly. On a reset date, the three P/L
components of an equity swap are calculated to arrive at a net P/L amount.
Since equity swaps are OTC instruments this amount will appear on your prime
broker account on the settlement date. Then the swap contract continues from
this point to the next reset date.
2.2.3.
Valuation Date (NAV date)
On
the NAV date, the equity swap must be valued. Once again, you must take into
account all three P/L components of the equity swap. On valuation date
there are no cash flows but rather unrealized equity P/L and accruals for
interest and dividends.
2.2.4.
Dividends
Since
the dividend is not paid from the actual company (the “short” side pays the
dividend), the swap participants don’t wait until pay date to actually pay to
the dividend. Instead, the dividend is paid on the first reset date on or
after the ex-date. This makes the administration more efficient since they
are combining the cash flows of the three P/L components at the same time.
Also
note that the typical withholding taxes would not apply with equity swaps
because there are no shares actually traded on a stock exchange.
2.3.
Why do Investors use Equity
Swaps?
Investors
trade swaps for several reasons:
2.3.1.
Leverage
This
is the main reason hedge funds use equity swaps. Leverage refers to the
fact that equity swaps do not cost anything to get into; they are contracts.
Therefore if the contract is profitable, the rate of return is much higher than
if they had actually traded the shares on a stock exchange.
2.3.2.
Illiquid Markets
A
hedge fund may wish to trade 100,000 shares of a stock. If the stock trades
only 10,000 shares per day, the fund could not quickly accumulate their desired
position without driving up the price of the shares. Entering into equity swap
contracts eliminates this problem since no shares are actually traded on a
stock exchange.
2.3.3.
Trade the Stock, not the
Currency
Trading
foreign stocks carries with it currency risk. This currency risk is normally
hedged with forward contracts. However since equity swaps are OTC instruments,
they can be transacted in any currency the investors wish. This removes the
currency risk and therefore no forward contracts are necessary.
2.4.
Trading an Equity Swap
Let’s look at an example. The fund wants to
go long (purchase) 10,000 shares of IBM US
Opening
of the contract (trade date = 12th day of the month / settlement date = 15th):
Purchase the 10,000 shares for $75.00 each.
This would create a notional of $750,000.00. Note that his “purchase” is not an
actual exchange traded purchase but rather a transaction type to identify that
your fund is on the “long” side of the contract. No cash has moved.
Reset
date # 1 (trade date = 19th day of the month / settlement date = 22nd):
Cash is exchanged on reset dates. The price
of IBM moved up from $75.00 to $75.50 since the purchase date. Remember the
three P/L components of an equity swap.
1) Equity Leg: The fund earned $0.50 per share. Therefore the equity
leg resulted in a profit of $5,000.00.
2) Interest Leg: The long side of the contract must always pay
interest to the short side based on the notional amount at a rate of
approximately the prime rate plus/minus a spread. The interest is calculated as
follows:
Notional
X interest rate X # of days / 365
=
750,000.00 X 5.40% X 7 / 365
=
$776.72
Therefore
the fund must pay $776.72.
3) Dividend Leg (if applicable): The long side of the contract will receive
a dividend from the short side if the dividend ex-date was on or
after the trade date of the last reset date or purchase date. In this
case, no dividend is applicable.
Now the reset calculations are complete.
Our long equity swap has a net cash flow of $4,223.28 which will appear on our
prime broker account on the settlement date.
Reset
date # 2 (trade date = 26th day of the month / settlement date = 29th):
Cash is exchanged on reset dates. The price
of IBM moved down from $75.50 to 75.25 since the last reset date. Remember the
three P/L components of an equity swap.
1) Equity Leg: The fund lost $0.25 per share. Therefore the equity leg
resulted in a loss of $2,500.00.
2) Interest Leg: The long side of the contract must always pay
interest to the short side based on the notional amount. Note that the
notional amount changes on each subsequent reset based on the previous reset
price. Also the interest rate may change because it is usually based on a prime
rate. The interest is calculated as follows:
Notional
X interest rate X # of days / 365
=
755,000.00 X 5.60% X 7 / 365
=
$810.85
Therefore
the fund must pay $810.85.
3) Dividend Leg (if applicable): The long side of the contract
will receive a dividend from the short side if the dividend ex-date
was on or after the trade date of the last reset date or purchase date.
In this case, no dividend is applicable.
Now the reset calculations are complete.
Our long equity swap has a net cash flow of $(3,310.85) which will appear on
our prime broker account on the settlement date.
Valuation
date (NAV date = 30th day of the month):
Unlike a reset date, no there is no cash
flow at valuation date. The price of IBM moved up from $75.25 to 76.00 since
the last reset date. Remember the three P/L components of an equity swap.
1) Equity Leg: The fund earned $0.75 per share. Therefore the equity
leg resulted in an unrealized gain of $7,500.00. Simply price the stock to
reflect the unrealized equity P/L.
2) Interest Leg: The long side of the contract must always pay
interest to the short side based on the notional amount. On valuation
date we must accrue for this upcoming payment. Note that the notional
amount changes on each subsequent reset based on the previous reset price. Also
the interest rate may change because it is usually based on a prime rate. The
interest is calculated as follows:
Notional
X interest rate X # of days / 365
=
752,500.00 X 5.65% X 1/365
=
$116.49
Therefore
the accrued interest expense at NAV date is $116.49.
3) Dividend Leg (if applicable): The long side of the contract
will accrue dividend income from the short side if the dividend ex-date
was on or after the trade date of the last reset date or purchase date.
In this case, no dividend is applicable, therefore no accrual is applicable.
Reset
date # 3 (trade date = 3rd day of the month / settlement date = 5th):
Cash is exchanged on reset
dates. The price of IBM moved up from $75.25
to 76.30 since the last reset date. Remember the three P/L components of an
equity swap.
1) Equity Leg: The fund earned $1.05 per share. Therefore the equity
leg resulted in a gain of $10,500.00.
2) Interest Leg: The long side of the contract must always pay
interest to the short side based on the notional amount. Note that the
notional amount changes on each subsequent reset based on the previous reset
price. Also the interest rate may change because it is usually based on a prime
rate. The interest is calculated as follows:
Notional
X interest rate X # of days / 365
=
752,500.00 X 5.65% X 7 / 365
=
$815.38
Therefore
the fund must pay $815.38.
3) Dividend Leg (if applicable): The long side of the contract
will receive a dividend from the short side if the dividend
ex-date was on or after the trade date of the last reset date or purchase date.
In this case, no dividend is applicable.
Now the reset calculations are complete.
Our long equity swap has a net cash flow of $9,684.62 which will appear on our
prime broker account on the settlement date.
Reset
date # 4 (trade date = 14th day of the month / settlement date = 21st):
Cash is exchanged on reset dates. The price
of IBM moved down from $76.30 to 76.10 since the last reset date. Remember the
three P/L components of an equity swap.
1) Equity Leg: The fund lost $0.20 per share. Therefore the equity leg
resulted in a loss of $2,000.00.
2) Interest Leg: The long side of the contract must always pay interest
to the short side based on the notional amount. Note that the notional amount
changes on each subsequent reset based on the previous reset price. Also the
interest rate may change because it is usually based on a prime rate. The
interest is calculated as follows:
Notional
X interest rate X # of days / 365
=
763,000.00 X 5.70% X 7 / 365
=
$834.08
Therefore
the fund must pay $834.08.
3) Dividend Leg (if applicable): The long side of the contract will
receive a dividend from the short side if the dividend ex-date was on or after
the trade date of the last reset date or purchase date. In this case there was
a dividend with an ex-date of the 8th of the month at a rate of $0.30 per
share. Therefore this dividend will be received on this reset date. The gross
dividend is calculated as follows:
Quantity
X dividend rate per share
=
10,000 X .30
=
$3,000.00
Now the reset calculations are complete.
Our long equity swap has a net cash flow of $165.92 which will appear on our
prime broker account on the settlement date.
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