Equity Swap
FinPricing offers:
Four user interfaces:
- Data API.
- Excel Add-ins.
- Model Analytic API.
- GUI APP.
Total Return Equity Swap Valuation
FinPricing provides valuation models for the following total return swaps:
- Equity Swap (Total Return Swap)
- Equity Swap with Reinvestment
- Equity Swap with Dividend Passthrough
- Equity Basket Swap
- Dividend Swap
- Equity Default Swap
- Equity Correlation Swap
- Equity-Linked Cancelable Swap
- Equity-Linked Participation Swap
- Bond Total Return Swap
- Loan Total Return Swap
- Check FinPricing valuation models
| 1. Total Return Equity Swap Introduction |
A total return swap is an agreement in which one party makes payments based on a set rate, either fixed or variable,
while the other party makes payments based on the total return of an underlying asset, which includes both the income it
generates and any capital gains. The underlying asset that is used can be anything, but is usually an equities index,
loan or a basket of assets.
The most common type of total return swap is equity swap where the underlying asset is a stock, a basket of stocks,
or a stock index. An equity swap is an OTC contract between two parties to exchange a set of cash flows in the future.
Normally one party pays the return based on capital gains and dividends realized on an equity security and the other
party pays the return based on a floating interest rate plus a spread. Total return swaps or equity swaps give investors
opportunity to capture the performance of an asset without actually owning it.
Total return swap or equity swap is a good vehicle for counterparties to transfer risk.
One party makes cash payments based on a predefined fixed or floating rate, whereas the other
party makes payments based on the total return of an underlying asset. The party receiving the total return gains
exposure to the performance of the reference underlying asset without actually owning it. Therefore, this product can
be used to obtain a leveraged exposure. On the opposite of the transaction, the counterparty receive payments of a
reference interest rate payments that provide some protection against a potential loss of the underlying asset.
The two cash flows are usually referred to as “legs” of the swap. The leg referred to as the floating
leg is pegged to a floating rate such as LIBOR. The other leg of the swap referred to as the equity leg is based on
the performance of either a share of individual stock or stock index. Unlike interest rate swaps,
the equity swap notional resets on each cash flow reset date, depending on the performance of the underlying asset.
Equity swaps allow parties to potentially benefit from returns of an equity security without the need to own its
shares. In general, a party enters an equity swap with the objective of either obtaining return exposure or hedge
existing equity risk for a period of time.
An equity swap can be used to transfer both the credit risk and the
market risk of an underlying asset. Equity swaps can be also used to avoid transaction
costs (including Tax), to avoid locally based dividend taxes, limitations on leverage (notably the US margin regime)
or to get around rules governing the particular type of investment that an institution can hold. Equity swaps can make
investment barriers vanish and help an investor create leverage.
| 2. Equity Swap Valuation |
There are two legs in an equity swap: an equity leg and a floating interest leg. The payoff for both legs could be
set at every reset date or at maturity; or could be one side at maturity and the other at every reset date. The price
of the swap is the difference between the present values of both legs’ cash flows. In other words, the present
value of swap is net of present value of “equity leg” and “money market leg”.
The present value of an equity asset is given by
The present value of dividends is given by
The present value of the equity leg is the sum of equity PV amd dividend PV.
The present value of a floating interest rate leg can expressed as
The present value of the equity swap from the equity receiver perspective is given by
This is so-called the projection based approach that applies to normal cases. However, if a client unwinds, the accrual based approach is desirable, where payoff is slightly different.
Practical Notes
- We consider discrete dividends only for the reasons described in equity future
- First, you need to generate cash flows based on the start time, end time and payment frequency of the leg, plus calendar (holidays), business convention (e.g., modified following, following, etc.) and whether sticky month end.
- Second, you need to construct an yield curve based on the most liquid interest rate instruments. FinPricing provides useful tools for various curves and volatility surfaces construction.
- Then, you need to compute equity forward prices correctly by accounting for all discrete dividends. This is a key factor for all equity related valuation.
- Accrual period is calculated according to the start date and end date of a cash flow plus day count convention
- Forward rate is contiously compounded rather than other compounding types
| 3. Related Topics |