Template:M summ Equity Derivatives 5.10
The Equity Notional Reset is a feature for automatically restriking the Equity Notional Amount on a periodic basis to the prevailing value of the Equity Notional Amount. It has the effect of converting posted collateral - which for financial institutions may suffer a punitive capital treatment - into absolutely paid amounts.
The swap will reset automatically on each Cash Settlement Payment Date, (i.e., usually a Settlement Cycle after each Valuation Date).
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.