Equity Swap in a derivative often used in heding and speculation both. It is one of the most popular product typically used in Hedge Funds and Private Equity business.
Following is a detailed note and calculation for the Equity Swap. Leave a comment if you have any query or question.
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. Definition and underlying assets
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 or COVER is booked.
2.1. Three P/L Components of an Equity Swap
Here 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. Shares of IBM trade at $75.00 per share. The equity swap contract expires in one month and has weekly reset dates. The equity swap would play out as follows:
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.
- Equity Leg: The fund earned $0.50 per share. Therefore the equity leg resulted in a profit of $5,000.00.
- 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.
- 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.
- Equity Leg: The fund lost $0.25 per share. Therefore the equity leg resulted in a loss of $2,500.00.
- 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.
- 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.
- 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.
- 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.
- 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.
- Equity Leg: The fund earned $1.05 per share. Therefore the equity leg resulted in a gain of $10,500.00.
- 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.
- 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.
- Equity Leg: The fund lost $0.20 per share. Therefore the equity leg resulted in a loss of $2,000.00.
- 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.
- 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.
A student of ACCA professional level, who is also working with a Big 4 firm, recently requested the tutor of Finsapient Institute to prepare a lesson on Equity Swap, which can be readily used in the accounting, valuation, investment management business and serves as a practical guide to various professionals. While ACCA papers are uniquely robust and holistic to train students on such capital market product, this may help many other accounting and finance professionals. This was a great thought to help others from a very young and budding accountant. Hence, Finsapient Institute agreed to prepare a very practical and methodical guide for everyone to understand Equity Swap and apply the concept in the workplace.
The details and rigours of this content will also be useful for those working in investment management and investment banking functions.
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. Definition and underlying assets
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 or COVER is booked.
2.1. Three P/L Components of an Equity Swap
Here 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. Shares of IBM trade at $75.00 per share. The equity swap contract expires in one month and has weekly reset dates. The equity swap would play out as follows:
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.
- Equity Leg: The fund earned $0.50 per share. Therefore the equity leg resulted in a profit of $5,000.00.
- 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.
- 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.
- Equity Leg: The fund lost $0.25 per share. Therefore the equity leg resulted in a loss of $2,500.00.
- 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.
- 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.
- 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.
- 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.
- 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.
- Equity Leg: The fund earned $1.05 per share. Therefore the equity leg resulted in a gain of $10,500.00.
- 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.
- 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.
- Equity Leg: The fund lost $0.20 per share. Therefore the equity leg resulted in a loss of $2,000.00.
- 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.
- 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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