Equity swaps ppt


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This is a basic idea PPT on Equity swaps

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Equity swaps ppt

  1. 1. Using derivatives to Manage riskThe case of Equity SwapPresentation by Krishnan Chari19th April 2013
  2. 2. What is a swap ? Let us assume that there are two different sequence ofcash flow across time periods being received by twodifferent entities. One series of a cash flow which represents the returnson an equity index or a stock. Let us denote this cash flow series as Ct1 as occurring intime t1 and Ct2 as occurring in time t2. Let the other series of a cash flow be a return linked to ashort term money market bench mark interest rate byway of spread. Say Libor-200 basis points. Let us denote this cash flow series as Bt1 as occurring intime t1 and Bt2 as occurring in time t2.5/16/2013
  3. 3. What is a swap ? In finance as we know any cash flow is subject touncertainty So each of the cash flow series C and B are exposed touncertainty So the cash flow which represents returns from anEquity Index ( like a Nifty, S&P500 or stock like IBM,TCS) are exposed to a set of market risk, credit riskfactors. Similarly the cash flows which are based on short termmoney market rates are also exposed to market risk andcredit risk factors.5/16/2013
  4. 4. What is a swap ? If the two entities receiving the cash flow C and B enterinto a financial contract to exchange the cash flows, thenit 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 equityreturns or interest cash flow Total return swap- exchange of an asset return againstinterest cash flow Currency swaps-exchange of cash flows in two differentcurrencies5/16/2013
  5. 5. Economic reasons for Equity Swap ?Motivation for swap contracts Managing balance sheet risk/portfolio risk To take long/short position on the asset withoutholding/selling the underlying asset physically i.esynthetic transaction Cost effective way for fund managers to replicate index Balance sheet management- Aligning exposures tocapital adequacy and institutional capability to managefinancial risk Aligning investment portfolios with the risk appetite Using equity swaps for funding/monetisation of asset5/16/2013
  6. 6. Understanding an Equity Swap ? A swap contract should be fair valued at the initiation ofthe transaction The pricing rule is to arrive at a spread adjustment suchthat the net present value of cash flow value should beequal to zero i.e at time T0 The spread that enables to equate the present values ofthe two legs of a swap i.e the receive and pay leg is theprice of a swap.5/16/2013
  7. 7. Equity Swap-an example Example of a Equity swap cash flow We have a 4 year sequence of cash flows generated by aS&p500 equity index. They are exchanged every 90 daysagainst a sequence of cash flows based upon 3 monthLibor -20 bps5/16/2013
  8. 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 onequity Investor can be a fund manager wanting to take equityexposure Receiver of libor a Bank which wants to reduce equityexposure5/16/2013
  9. 9. Reflecting a real life scenarioBank dealer( hasexistingequityexposure )Fund manager(desires to haveequity exp)Bank pays equity returnsFund manager pays libor The Bank has existing equity exposure which it wants toconvert into credit risk as the capital charge for capital marketexposure is high.The bank dealer is pessimistic about equity performance The fund manager wants specific exposure to Equity hence insearch of a synthetic transactionTransaction takes place due to comparative advantage inmanaging specific asset class risk in line with balance sheetcomposition.5/16/2013
  10. 10. Reflecting upon a real life scenario In this example we can have the following scenario Bank has equity exposure which attracts higher capitaladequacy It wants to convert its equity exposure to interest rate/creditrisk exposure which it can hedge better On the other hand the fund manager wants synthetic exposureto equity to reduce cost of replication and transaction Hence to meet both ends Bank dealer and the fund houseenter into a equity swap. Bank hedges its new interest rate exposure by interestforward rates/FRA and credit exposure through proper duediligence of fund house and choosing only AA rated funds asits counterparty. The fund manager can also hedge his synthetic equityexposure through index futures/options. 5/16/2013
  11. 11. Equity swaps conventions Equity swaps with constant notional Equity swaps with variable notional Equity swaps with cross currency cashflow5/16/2013
  12. 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, Theswaps and Financial derivatives library, John Wiely5/16/2013