Template:M gen Equity Derivatives 5

On the difference between Final Price and Relevant Price

Final Price is defined in Article 5 of the 2002 ISDA Equity Derivatives Definitions and is germane therefore to Equity Swap Transactions only and not, say, Forward Transactions (which, circuitously, rely instead on Relevant Price, albeit defined in a similar way).

The Final Price also has separately broken-out scenarios for Basket Transactions (being just the weighted sums of the individual components in the basket). Relevant Price doesn’t bother to break these out — whether that is because Share Basket Forwards behave differently to Basket Swaps, or just because ISDA’s crack drafting squad™ was losing the will to live, is a question to which we have yet to get to the bottom.

Don’t hold your breath.

VWAP adjustments to Final Price for US Shares

Where share Final Price is determined by reference to the Volume Weighted Average Price during a trading session you may see this following amendment:

(a) Section 6.3(a) is amended by deleting “at any time during the one hour period that ends at the relevant Valuation Time, Latest Exercise Time, Knock-in Valuation Time or Knock-out Valuation Time, as the case may be” and replacing it with “at any time during the regular trading session on the Exchange, without regard to after hours or any other trading outside of the regular trading session hours”.

(b) Section 6.3(d) is amended by deleting the remainder of the provision following the term “Scheduled Closing Time” in the fourth line thereof;

(c) If the final Valuation Date is a Disrupted Day, the Calculation Agent may determine that such day is a Disrupted Day only in part, in which case the Calculation Agent must designate the Valuation Date determined pursuant to Section 6.6(a) for the remaining portion and the Calculation Agent must adjust the Number of Shares for which the Disrupted Day is the Valuation Date and must determine the Final Price based on such adjustments which will be based on such factors as the Calculation Agent considers relevant.

The current US tax interpretation is that benchmarking an equity swap on a US Share to the close is viewed a cross (and one is guilty until proven innocent). Therefore, do not use the official closing price for US Shares at maturity as it would then invalidate them as true derivatives and recharacterise them as repos. Instead, confirm VWAP over the day as an observable benchmark price for termination.

This does not, however, prevent one early-terminating an Equity Swap Transaction on a US Share using methods other than VWAP. Now, if you are a synthetic prime brokerage sort of camper, you might wonder why all this fuss as equity swaps are treated, for most purposes, as undated and are always terminated at the client’s motion as an optional early termination.

How Equity Notional Reset works

Strap yourselves in, kids!

A beginner’s guide to the complex and tortuous world of what happens when your Equity Notional Amount is subject to Equity Notional Reset.

The short version’s really quite easy: You just restrike the trade at the market value, and pay out the difference in the value of the underlier over the reset period. As follows:

• On each Cash Settlement Payment Date, you pay the difference between the prevailing Initial Price (being the Equity Notional Amount before the CSPD) and the present market value of the stock on the CSPD (the Final Price).
• You then adjust the Equity Notional Amount to be equal to that Final Price.
• When the next CSPD rolls around, the new Equity Notional Amount is the Initial Price and you do it all over again.

The long version’s a bit of a ball-breaker:

• If Equity Notional Reset (5.10) applies, then on each Cash Settlement Payment Date you have to adjust the Equity Notional Amount by the Equity Amount.
• The Equity Amount (8.7) equals the Equity Notional Amount times the Rate of Return.
• The Rate of Return (5.7) is ((Final Price - Initial Price)/Initial Price) * any Multiplier
• The Final Price is the market value of the Share on the Valuation Date
• Initial Price is the price specified in the confirm (as adjusted by this glorious mechanic).
• You pay out the Equity Amount on the Cash Settlement Payment Date, and adjust the Equity Notional Amount accordingly.

It’s like converting a posted variation margin into an absolute obligation by restriking the Transaction.