Equity Swaps Explained: Mechanics and Variations | FRM Part 1 | CFA Level 2

In this video we'll be talking about equity swaps. An equity swap is an OTC derivatives contract in which the two parties involved, they periodically agree to exchange amongst themselves two series of cash flows, one of which is linked to or let's say it's tied to the performance of a chosen equity. To make more sense of this definition and to understand how equity swaps work, let's take a very quick example. Let's say there is a hedge fund and this hedge fund wants to get a synthetic long exposure to the price of a chosen equity. Let this equity be for example the stock of Apple. Now synthetic long exposure essentially means that the hedge fund wants to benefit from the periodic returns offered by Apple but it does not want to use cash from its own pocket to buy shares of Apple. This is where an equity swap can come in handy. Therefore what this hedge fund does is that it calls up the sales desk of its preferred investment bank and it asks this investment bank to structure or let's say customize an equity swap for it, an equity swap which references the stock of Apple. The investment bank then what it does is that together with the hedge fund it finalizes the attributes or let's say the terms and conditions of this equity swap and these attributes have been listed here. Number one, the underlying asset for this equity swap will be the stock of Apple. In the context of this equity swap we can also refer to this underlying asset to be the reference instrument. Number two, the size of the equity swap also referred to as the notional amount, let it be 10 million dollars, once the size has been decided upon the investment bank goes ahead and purchases shares of Apple for a dollar amount which is equal to 10 million which is the notional. These shares of Apple they belong to the investment bank. This long position in the shares of Apple is a position which will sit on the balance sheet of this investment bank and going forward this position becomes the source of periodic returns which can then be transferred over to the hedge fund via the equity swap. Number three, we have to decide upon the positions of each of these two parties involved in the swap. The hedge fund because it wants a synthetic long exposure to the price of Apple stock, this hedge fund in this equity swap becomes the party which will periodically receive the equity linked cash flow and in return let's say will pay a cash flow which is calculated using a fixed rate of interest. Then the other attributes which have to be decided are number four, the frequency of these exchanges. Let's say these exchanges happen every three months. Number five, the maturity of this swap. Let it be one year and number six, the day count convention. Let it be 30 over 360. So, in this equity swap, what has the hedge fund signed up for? Basically, we are talking about a one year equity swap here, a swap in which there will be four exchanges. Every exchange happens after a period of three months and in this equity swap, at the end of each three-month period, the hedge fund, it receives a cash flow which is calculated simply as the notional amount times the return offered by Apple over the settlement period which has just concluded. In return, the hedge fund pays out a cash flow which is simply notional amount, this times the duration of the settlement period expressed in years and this times a fixed rate of interest. Now, as of now, I haven't really told you what this fixed rate of interest is. Now, at the inception of this equity swap, the investment bank, it basically prices this equity swap which means that it calculates this fixed rate of interest such that the value of this equity swap at its inception is equal to zero for both the hedge fund as well as the investment bank. It starts off as a fair equity swap for both parties involved. Let's say this fixed rate of interest, it comes out to be 1.8 percent per annum. It's an annualized number. What we can do now very quickly is that we can take a look at how these cash flow calculations are done based on the return offered by Apple over any given three-month period. Let's say over a given three-month period, the underlying which is the stock of Apple has gone up by six percent. Well, if this is the case, then the equity linked cash flow would simply be the notional amount which is 10 million times six percent and this gives you 600,000. The fixed cash flow would simply be the notional amount, this 10 million times the duration of the settlement period expressed in years, so that will be 0.25 because the settlement period is three months and this times the fixed rate of interest which is 1.8 percent. This gives you the fixed cash flow to be 45,000. From the hedge fund's perspective, it will be receiving this amount which is 600,000 and it will be paying this amount which is 45,000. Both of these, they are in the same currency but they are in different directions and therefore netting can be done and on a net-net basis, the hedge fund will receive an amount which is 555,000 from the investment bank. Now, if during the three-month settlement period, the underlying let's say had gone down by four percent, then the equity linked cash flow would simply be notional amount 10 million times this minus four percent. So, this gives you a cash flow of minus 400,000. Minus here means that the hedge fund will have to pay this cash flow and not receive this cash flow as was the case here. The fixed cash flow is still 45,000. Again, from the hedge fund's perspective, these two cash flows will need to be aggregated and on a total or aggregate basis, the hedge fund would need to pay a total of $445,000 to the investment bank. Now, from the hedge fund's perspective and specifically for this kind of a situation, the hedge fund has to keep this thing in mind that if the underlying ends up going down like it did here, the total of these two cash flows can come out to be a substantial amount and the hedge fund owes both of these to the investment bank. So, this kind of a situation can prove to be a drag on the liquidity situation of the hedge fund. It will have to ensure that it has enough cash in its buffers for it to be able to honor this obligation towards the investment bank. So, on a net basis, through this equity swap, what has the hedge fund achieved? Well, if the underlying, which is the stock of Apple, goes up, the hedge fund, it received this positive cash flow from the investment bank. It stands to gain if the chosen equity does go up. If the underlying actually goes down, the hedge fund stands to lose. It had to pay this equity-linked cash flow to the hedge fund. So, these two scenarios, they clearly portray this that through this equity swap, the hedge fund indeed has obtained a synthetic long exposure to the price of the chosen equity. Now, it's a synthetic exposure because the hedge fund did not invest cash from its own pocket to purchase these shares of Apple. It's the investment bank which purchased these shares. These shares are sitting on the balance sheet of the investment bank. And in some sense, this hedge fund is renting the balance sheet of this investment bank. And in return, periodically, it's paying a fees which is calculated at this rate, which is 1.8% per annum. Now, let me do this. Let me very quickly take you through other possible variations of equity swaps. Variations beyond what we've seen just now in this example. Well, the first type of variation can arise because of the notional amount of the equity swap. In this example, we assumed that the notional amount is fixed. In reality, the notional amount can also very well be variable, which means that at the beginning of each settlement period, the notional amount can be reset. Then, another set of variations of equity swaps arise with respect to the treatment of dividends when it comes to calculation of the returns of the chosen equity. If dividends are not included in this return calculation, then that equity swap is referred to as a price return equity swap. If dividends are indeed included in the return calculation, then that equity swap is called a total return equity swap. Then, with respect to this cash flow, which the hedge fund was periodically paying to the investment bank, in this example, this cash flow was calculated using a fixed rate of interest. In other variations of equity swaps, this cash flow could very well have been calculated using a floating rate of interest. For example, LIBOR, or for that matter, any of the replacement rates for LIBOR. This cash flow could very well have been calculated using the performance of another equity. So, an equity swap can very well be a swap which exchanges the performance of two different equities. Then, variations also exist on account of the type of reference instrument. Now, in this example, it was a single equity which was our reference instrument. Reference instruments in equity swaps can very well be equity indices, or for that matter, custom portfolios containing single stocks as well as indices. Now, before I finish off this video, let's quickly take a look at the various pros and cons from the hedge fund's perspective of gaining this exposure to the reference instrument via the equity swap versus directly investing in the reference instrument. The hedge fund, because it used an equity swap for this purpose, benefited on account of, number one, a lower initial outlay. Direct investment in the reference instrument would have called for a much larger upfront investment. Number two, gaining exposure to the reference instrument via the equity swap means that the hedge fund is not subject to disclosure requirements which direct owners of reference instruments may be subject to if the position constitutes a very material position. Number three, the hedge fund can save on taxes, stamp duties I mean, and also save on custodial fees related to direct investment in the reference instrument. Number four, if the reference instrument, let's say, trades in a restricted market, for example, an emerging market, direct investment in the reference instrument may not be possible. And hence, the hedge fund may only have this possible option of investing in this reference instrument via the equity swap. Lastly, number five, equity swaps can help reduce operational workloads when it comes to investing in your chosen reference instrument, especially if your reference instrument is, let's say, an index or, let's say, a custom portfolio that contains many, many stocks, for example. So, for example, if there is a rebalancing required, or for that matter, if there is, let's say, a corporate action, then in those situations, investing via the equity swap can help reduce your operational workload, because all these operational aspects will be handled by the investment bank. On the downside, I mean, the downside of using equity swaps to gain exposure to your chosen reference entity, remember this, that equity swaps are OTC derivatives contracts. And therefore, there is this element of counterparty credit risk which needs to be taken care of. So, in this equity swap, the investment bank would really want to subject this hedge fund to some kind of a collateral arrangement. If, let's say, the value of the chosen reference instrument were to go down, then in that situation, the investment bank will issue a margin call to this hedge fund and ask this hedge fund to post more collateral, more margin. If the hedge fund does not entertain this request for more margin, then the investment bank will actually close out this position. Then, please also note this, that equity swaps can prove to be a very illiquid way of gaining exposure to your chosen reference instrument. Just in case, the hedge fund wants to unwind this equity swap prior to its stated maturity date, then unwinding this swap can prove to be troublesome. Lastly, getting the exposure to your reference instrument via an equity swap will not give you the voting rights, which direct investment in your reference instrument will provide to you. This wraps up this video on equity swaps. If you found this video helpful, please do give it a thumbs up. If you are new to this channel, please do consider subscribing. Please visit the homepage of finrgb.com for detailed courses on FRM part 1 and FRM part 2. Thank you for watching and I will see you in the next video.