Slideshare uses cookies to improve functionality and performance, and to provide you with relevant advertising. If you continue browsing the site, you agree to the use of cookies on this website. See our User Agreement and Privacy Policy.

Slideshare uses cookies to improve functionality and performance, and to provide you with relevant advertising. If you continue browsing the site, you agree to the use of cookies on this website. See our Privacy Policy and User Agreement for details.

Like this presentation? Why not share!

10,046 views

9,279 views

9,279 views

Published on

This is a basic idea PPT on Equity swaps

No Downloads

Total views

10,046

On SlideShare

0

From Embeds

0

Number of Embeds

2

Shares

0

Downloads

164

Comments

0

Likes

2

No embeds

No notes for slide

- 1. Using derivatives to Manage riskThe case of Equity SwapPresentation by Krishnan Chari19th April 2013
- 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. 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. 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. 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. 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. 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. 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. 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 transactionTransaction takes place due to comparative advantage inmanaging specific asset class risk in line with balance sheetcomposition.5/16/2013
- 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. Equity swaps conventions Equity swaps with constant notional Equity swaps with variable notional Equity swaps with cross currency cashflow5/16/2013
- 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

No public clipboards found for this slide

×
### Save the most important slides with Clipping

Clipping is a handy way to collect and organize the most important slides from a presentation. You can keep your great finds in clipboards organized around topics.

Be the first to comment