The Jolly Contrarian

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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:

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

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

Types of return when referencing futures

If you have an Equity Swap Transaction referencing a future, some debate — not all of it necessarily fruitful, but undoubtedly special in the hearts of those who enjoy metaphysical conundrums — can be had as to whether one should select Price Return or Total Return as your Type of Return, but since futures don’t generally pay dividends, on point of practical fact there is not a lot of difference, so such debate can aggravate intensely practical people such as my little sister, who despair of metaphysical conundrums.

But okay, dammit, let’s hop off the fence and stick Occam’s razor into the ointment: Since Total Return is Price Return with some extra fiddly bits relating to dividends — including the need to choose whether or not you want your dividends deemed to be reinvested — then all other things being equal — such as when, as for futures, there are no dividends for you to elect whether or not to reinvest — Price Return is the simpler, and therefore preferred, definition. There: for Equity Swaps on futures, go for Price Return.

Shorts, longs and flexi-transactions

Now as you know, the ISDA Master Agreement is a bilateral construct — In a funny way, a bit Bob Cunis like that — and while the equity derivatives market is largely conducted between dealers and their clients, this doesn’t mean the dealer is always the Equity Amount Payer. The client — as often as not, a hedge fund — is as likely to be taking a short position — locusts, right? — as a long one. One does this by reversing the roles of the parties in the Confirmation: The Equity Amount Payer for a long transaction will be a dealer. The Equity Amount Payer for a short transaction will be the fund.

So much so uncontroversial. But then there are flexi-transactions: in these modern times of high-frequency trading, unique transaction identifiers and trade and transaction reporting, dealers and their clients are increasingly interested in consolidating the multiple trade impulses they have on the same underlyer into single positions and single transactions: this makes reconciling reporting far easier, and also means you don’t have to be assigning thousands of UTIs every day — at a couple of bucks a throw — to what is effectively a single stock position.

What does this have to do with Equity Notional Amounts? Well, the Equity Notional Amount of that single “position” transaction is now a moving target. A short trade impulse on a (larger) existing long position will reduce the Equity Notional Amount, but it won’t necessarily change who is the Equity Amount Payer, unless the total notional of the position flips from positive to negative. Then it will. This is kind of weird if you stand back and look at it from a stuffy, theoretical point of view, but once you slip into that warm negligee of pragmatism in which almost all legal eagles love to drape themselves, you get over it.

Well, I did, anyway.

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