This is a basic idea PPT on Equity swaps

1. Using derivatives to Manage risk
The case of Equity Swap
Presentation by Krishnan Chari
19th April 2013

2. 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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3. 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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4. 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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5. 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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6. 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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7. 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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8. 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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9. 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 transaction
Transaction takes place due to comparative advantage in
managing specific asset class risk in line with balance sheet
composition.
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10. 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. 5/16/2013

11. Equity swaps conventions
 Equity swaps with constant notional
 Equity swaps with variable notional
 Equity swaps with cross currency cashflow
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12. 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
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