Using derivatives to Manage risk

The case of Equity Swap

Presentation by Krishnan Chari

19th April 2013

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What is a swap ? Let us assume that there are two different

sequence of cash flow across time periods being received by two different entities.

One series of a cash flow which represents the returns on an equity index or a stock.

Let us denote this cash flow series as Ct1 as occurring in time t1 and Ct2 as occurring in time t2.

Let the other series of a cash flow be a return linked to a short term money market bench mark interest rate by way of spread. Say Libor-200 basis points.

Let us denote this cash flow series as Bt1 as occurring in time t1 and Bt2 as occurring in time t2.

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What is a swap ? In finance as we know any cash flow is subject to

uncertainty So each of the cash flow series C and B are

exposed to uncertainty So the cash flow which represents returns from

an Equity Index ( like a Nifty, S&P500 or stock like IBM, TCS) are exposed to a set of market risk, credit risk factors.

Similarly the cash flows which are based on short term money market rates are also exposed to market risk and credit risk factors.

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What is a swap ? If the two entities receiving the cash flow C and B

enter into a financial contract to exchange the cash flows, then it is a Swap !

Types of swaps entered between two market participants

Interest rate swap- exchange of interest cash flows Equity Swap-exchange of equity returns with

equity returns or interest cash flow Total return swap- exchange of an asset return

against interest cash flow Currency swaps-exchange of cash flows in two

different currencies

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Economic reasons for Equity Swap ?Motivation for swap contracts Managing balance sheet risk/portfolio risk To take long/short position on the asset without

holding/selling the underlying asset physically i.e synthetic transaction

Cost effective way for fund managers to replicate index

Balance sheet management- Aligning exposures to capital adequacy and institutional capability to manage financial risk

Aligning investment portfolios with the risk appetite Using equity swaps for funding/monetisation of

asset

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Understanding an Equity Swap ? A swap contract should be fair valued at the

initiation of the transaction

The pricing rule is to arrive at a spread adjustment such that the net present value of cash flow value should be equal to zero i.e at time T0

The spread that enables to equate the present values of the two legs of a swap i.e the receive and pay leg is the price of a swap.

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Equity Swap-an example Example of a Equity swap cash flow We have a 4 year sequence of cash flows

generated by a S&p500 equity index. They are exchanged every 90 days against a sequence of cash flows based upon 3 month Libor -20 bps

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Buy sell side of the swap trade Investor is the receiver of the equity cash flow Investor is long on equity The receiver of the libor rate is the dealer who is

short on equity Investor can be a fund manager wanting to take

equity exposure Receiver of libor a Bank which wants to reduce

equity exposure

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Reflecting a real life scenario

Bank dealer( has

existing equity

exposure )

Fund manager(desires to have

equity exp)

Bank pays equity returns

Fund manager pays libor

The Bank has existing equity exposure which it wants to convert into credit risk as the capital charge for capital market exposure is high. The bank dealer is pessimistic about equity performance

The fund manager wants specific exposure to Equity hence in search of a synthetic transactionTransaction takes place due to comparative advantage in managing specific asset class risk in line with balance sheet composition.

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Reflecting upon a real life scenario In this example we can have the following scenario Bank has equity exposure which attracts higher capital

adequacy It wants to convert its equity exposure to interest rate/credit

risk exposure which it can hedge better On the other hand the fund manager wants synthetic exposure

to equity to reduce cost of replication and transaction Hence to meet both ends Bank dealer and the fund house

enter into a equity swap. Bank hedges its new interest rate exposure by interest forward

rates/FRA and credit exposure through proper due diligence of fund house and choosing only AA rated funds as its counterparty.

The fund manager can also hedge his synthetic equity exposure through index futures/options.

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Equity swaps conventions Equity swaps with constant notional Equity swaps with variable notional Equity swaps with cross currency cashflow

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References for further reading Principles of financial engineering by Salih Neftci,

Academic press, second edition 2008 PRM handbook Derivatives products and pricing by Satyajit Das,

The swaps and Financial derivatives library, John Wiely