Cash Settlement - Equity Derivatives Provision
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2002 ISDA Equity Derivatives Definitions
A Jolly Contrarian owner’s manual™ 8 in a Nutshell™
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8 Cash Settlement
Section 8.1 Cash Settlement of Option Transactions
Section 8.2 Option Cash Settlement Amount
Section 8.3 Strike Price Differential
Section 8.4 Cash Settlement of Forward Transactions
Section 8.5 Forward Cash Settlement Amount
Section 8.6 Cash Settlement of Equity Swap Transactions
- 8.6(a). Price Return
- 8.6(b). “Total Return” and “Re-investment of Dividends” is not applicable
- 8.6(c). “Total Return” and “Re-investment of Dividends” is applicable
Section 8.7 Equity Amount
Section 8.8 Cash Settlement Payment Date
Compare Section 8.6 with Physical Settlement of Equity Swap Transactions under Section 9.3, which I am bound to say is a lot less fraught.
Basics
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.
Section 8.6: Cash Settlement of Equity Swap Transactions
Equity Swap Transactions can be settled either by reference to Price Return or Total Return.
Under Section 8.6 (Cash Settlement of Equity Swap Transactions) where “Cash Settlement” applies, a payment is made on each Cash Settlement Payment Date depending on the Type of Return specified as follows:
Price Return
Price Return is simply a function of the price at the beginning and end, and takes no account of declared dividends or other income or distributions received off the underlier in the meantime. It is simply
Where “Rate of Return” is
((Final Price - Initial Price)/Initial Price) * any Multiplier
The Equity Amount is paid one way or the other depending on whether it is positive or negative.
Total Return
Total Return is the Price Return, but adjusted for income.
Where Re-investment of Dividends does not apply, the Equity Amount Payer must pay Dividend Amounts along with the Equity Amount, whichever way it might be paid, as per Price Return.
Where Re-investment of Dividends does apply, then Equity Amounts will be adjusted as per the “Re-investment of Dividends” provision.
Section 8.7: Equity Amount
Equity Amounts, then. Straightforward enough: Take your Equity Notional Amount — helpfully filled out in the Confirmation — multiply it by the Rate of Return, being the performance of the underlying share over the period in question — and there’s your number.
Let’s put some numbers on this, because, as with many of the finer creations of ISDA’s crack drafting squad™, there is quite a lot of buried technology in there to unpack.
The first component is the Rate of Return. This is a calculation of the performance of the Share over the period, times a Multiplier which might apply if you are doing some kind of kooky leveraged trade, but more likely will account for capital gains or stamp duty payable by the broker on the underlying hedge — so you might expect something like 85%. But that makes the mathematics too complicated for this old fellow, so let’s call the Multiplier 100%, so you can ignore it, and say the Initial Price is 100. And let’s do two scenarios: where the stock has gone up — here say the Final Price is 105, and where the stock has gone down — here, say the Final Price is 95.
The Rate of Return formula is (Final Price - Initial Price)/Initial Price) * Multiplier, which works out as:
- Where the stock went up: (105-100)/100 * 100% = 5/100 = +5%.
- Where the stock went down: (95-100)/100 * 100% = -5/100 = -5%.
Now to calculate your Equity Amount, we take the Equity Notional Amount (for ease of calculation, say USD1,000,000?) and times it by the Rate of Return:
- Where the stock went up: USD1,000,000 * +5% = USD+50,000.
- Where the stock went down: USD1,000,000 * -5% = USD-50,000.
Section 8.8: Cash Settlement Payment Date
A provision that does very little to help an inquiring mind with the question “What is the Cash Settlement Payment Date actually, like, for?”
For that, you would be advised to consult Section 8.6, Cash Settlement of Equity Swap Transactions, which differentiates between “Price Return”, which concerns itself purely with the prevailing equity price of the underlier, and “Total Return” which also factors in dividends paid on the relevant stock, and “slight return”, which is a Jimi Hendrix song.[1]
Note: Dividend Amounts are typically payable on the Cash Settlement Payment Date — though the Cash Settlement Payment Date following what — that is the question, whose answer, it turns out, is a little bit odd, as you will see if you investigate further.
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See also
- Equity Notional Reset which provides for the automatically re-striking of the Equity Notional Amount on each Cash Settlement Payment Date.
- Futures and exchange-traded derivatives
- Not to be confused with Futures Price Valuation
- Slight return
References
- ↑ It doesn’t really relate to slight return, though that is a Jimi Hendrix song.