Equity Notional Reset - Equity Derivatives Provision
Content and comparisons
Article 5 General Terms Relating to Equity Swap Transactions
Section 5.1. Equity Amount Payer
Section 5.2. Equity Amount Receiver
Section 5.3. Initial Exchange Amount
Section 5.4. Initial Exchange Date
Section 5.5. Final Exchange Amount
Section 5.6. Final Exchange Date
Section 5.7. Rate of Return
Section 5.8. Initial Price
Section 5.9. Final Price
Section 5.10. Equity Notional Reset
Summary
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2002 ISDA Equity Derivatives Definitions A Jolly Contrarian owner’s manual™
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Overview
Article 5 General Terms Relating to Equity Swap Transactions
Section 5.1. Equity Amount Payer
Section 5.2. Equity Amount Receiver
Section 5.3. Initial Exchange Amount
Section 5.4. Initial Exchange Date
Section 5.5. Final Exchange Amount
Section 5.6. Final Exchange Date
Section 5.7. Rate of Return
Section 5.8. Initial Price
Section 5.9. Final Price
Section 5.10. Equity Notional Reset
Summary
Equity Amount Payer: Not of itself a wildly interesting definition but the question of when one is an Equity Amount Payer — when you are long, and not when you are short — is not entirely intuitive. The Equity Amount Payer is the equivalent of a “Seller” in an Option Transaction. The person paying away the equity performance. If the customer is long, the swap dealer. If the customer is short, the customer.
Equity Amount Receiver: Used in the context of Price Return Transactions, where the amount is payable by the Equity Amount Payer of the equity or index performance is positive, but (its absolute value) payable by the Equity Amount Receiver is the price return is negative.
Final Exchange Amount: In a delta-one Equity Swap Transaction, there is unlikely to be one. Maybe if the swap has a cross-currency element you might exchange notional amounts, or if it is some kind of par-asset swap.
Rate of Return: Used in calculating the Equity Amount, which is the amount you pay our on a Cash Settlement Payment Date.
Initial Price: Used in Rate of Return, which in turn is used in Equity Amount, and also very relevant to the Equity Notional Reset process. The Initial Price is different to the Equity Notional Amount in that it is expressed as a price per Share, whereas the Equity Notional Amount tends to be Initial Price * Number of Shares.
Note there is an initial Initial Price — the strike price in the Confirmation — but it is reset on every Valuation Date to the Final Price on that date — so the prevailing Initial Price fluctuates over time.
The way the Initial Price definition is drafted, you don’t need to say “... subject to adjustment on each Valuation Date” in the Confirmation, although for many of you this is sure to prove an irresistible temptation.
Final Price: Note that Final Price isn’t necessary the final Final Price: you determine a fresh Final Price on every Valuation Date, as of the Valuation Time, and they feed into the Cash Settlement (or Equity Notional Reset) process, whereby one party pays out the movement price of the underlier over the period since the last Valuation Date.
Thus, Final Price for today’s Valuation Date becomes the Initial Price for the next Valuation Date, and so on and so on — yesterday’s rooster is today’s feather duster so to say.
Only on the final Final Price does the Transaction terminate and that contingency — you know, calling it quits and wrapping the whole thing up — isn’t addressed in any particular way in the definitions booklet, the presumption being that you will just follow the same procedure as you would for any other Valuation Date on the last one. This might give your US Tax guy the heebie-jeebies, be warned, as he will want VWAP, or some kind of hypothetical broker dealer referenced in the very last one. Dash cold water in his face if so, and tell him to get it together, man.
Final Price in Synthetic prime brokerage
Where you are doing synthetic equity swaps, the Final Price on the Termination Date — the very one which gives your tax guy the heebie-jeebies — is mainly of academic interest, as it will only be a jowl-slappingly fortuitous coincidence if a client happens to go off risk at exactly the scheduled Termination Date.
In fact, a synthetic equity swap is an indefinite arrangement — it is replicating cash prime brokerage, remember, where a fellow holds (or shorts) a security at her own pleasure, so to speak — so the client can terminate at any time, and if it doesn’t terminate by the scheduled Termination Date she will typically want to roll the position (if she can[1]) without realising a gain or loss. Thus the Termination Date is fairly arbitrary, existing really only to avoid syntax errors in a booking system which will insist on you inputting one, or to resolve the unspoken anguish of your financial reporting folk who may otherwise fear you have an undated exposure to the underlying security[2].
Equity Notional Reset: The Equity Notional Reset is a feature for automatically restriking the Equity Notional Amount on a periodic basis to its prevailing value. It has the effect of converting posted collateral — which for financial institutions may suffer a punitive capital treatment — into realised profit and loss; and therefore no longer contingent liabilities to pay cash amounts.
Am equity swap will reset automatically on each Cash Settlement Payment Date, (i.e., usually a Settlement Cycle after each Valuation Date).
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- The JC’s famous Nutshell™ summary of this clause
- On the difference between Final Price and Relevant Price
- VWAP adjustments to Final Price for US Shares
- How Equity Notional Reset works
See also
- Equity Notional Amount
- Equity Notional Reset, the process by which your trade is re-struck on each Valuation Date.
- Volume Weighted Average Price (VWAP)
- Relevant Price
References
General discussion
Example
Let’s say:
- a swap is struck with an initial Equity Notional Amount of £10m
- the swap is now out of the money to Party A by £1mm.
- Party A has therefore posted £1mm in collateral to Party B.
An Equity Notional Reset would operate as follows:
- The Equity Notional Amount would be reset at £9mm (the calculation being original Equity Notional Amount + Equity Amount, which in this case would be £10mm + £-1mm = £9mm)
- In consideration for this reduction in the Equity Notional Amount, Party A would become liable to pay an exchange amount of £1mm.
- at the same time Party B's exposure to Party B would be reduced to nil, meaning Party B would be oblished to return £1mm of equivalent credit support.
- The return of credit support would be netted off against the exchange amount due, meaning no cashflow would take place.
Result: instead of the swap being out of the money by £1mm and collaterased by that amount, the restruck swap has a MTM of 0 and neither party holds any collateral.
Cash Settlement mechanics generally
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.
Bullet swaps
Remembering, of course that the “calculation period” for an Equity Amount Payer is a function of the specified Valuation Dates — there is no specific concept of a “calculation period” in the 2002 ISDA Equity Derivatives Definitions — If the only specified Valuation Date is the Termination Date, then the whole Equity Notional Reset is moot, since no Equity Notional Reset will occur during the life the Transaction in any case.
User Guide
Adapted from the User Guide:
Equity Notional Reset has been amended from the 1996 Definitions by Section 5.10 of the 2002 Definitions to reflect the change in terminology from "Equity Payment Date” to "Cash Settlement Payment Date".
If "Equity Notional Reset” is specified then for the first Cash Settlement Payment Date, the Equity Notional Amount is the amount specified in the Confirmation and, for subsequent Cash Settlement Payment Dates, it is the sum of the Equity Notional Amount in respect of the prior Cash Settlement Payment Date and the Equity Amount in respect of the prior Cash Settlement Payment Date.
Lastly, if a "Notional Amount” has been specified in the Confirmation, such amount will be adjusted as set forth in Sections 5.10(a) and (b) as though it were an Equity Notional Amount.
If parties wish to extend the Floating Amount Payer Calculation Period in the situation where a Payment Date does not correspond with a Cash Settlement Payment Date, they should consider including the following additional language to the end of the definition of Payment Date:
"provided that, if on such date the corresponding Cash Settlement Payment Date has not yet occurred, such Payment Date shall be postponed to the date on which the Cash Settlement Payment Date occurs and the Floating Amount Payer shall pay the Floating Amount due in relation to the relevant Calculation Period on that postponed Payment Date."
As an alternative to extending the Floating Amount Payer Calculation Period in this situation, the parties may wish to defer payment of the Floating Amount to the Cash Settlement Payment Date, and accrue interest during that period. lf the parties wish to take that approach, they may wish to consider adding the following language:
", provided that, if on such date (the "Original Payment Date") the corresponding Cash Settlement Payment Date has not yet occurred, (i) the Calculation Period will be deemed to end on (but exclude) the Original Payment Date, (ii) interest will accrue on the Floating Amount from (and including) the Original Payment Date to (but exch1ding) the Cash Settlement Payment Date at [ ] calculated on the basis of daily compounding and the actual number of days elapsed and (iii) the Floating Amount Payer shall pay the relevant Floating Amount, together with any accrued interest, on the Cash Settlement Payment Date".
See also
Template:M sa Equity Derivatives 5.10
References
- ↑ There are complicated US Tax rules at play here
- ↑ Not, in fact true, as the broker-dealer will almost certainly have a right to terminate on (a month or more’s) notice, but do not expect this to placate a financial controller.