Dilution or Concentration Event - Equity Derivatives Provision

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Variations on the unwieldy phrase “a diluting or concentrative effect on the theoretical value of the relevant Shares” appears seven times in the 2002 ISDA Equity Derivatives Definitions, which is more than enough. The issue is this: you strike an equity swap at a given price, reflecting the prevailing capital value of the shares in question, but expressed by reference to a number of Shares. Say, 1,000 Tesla shares. It being a delta-one product off goes your swap dealer, buys 1000 Tesla Shares, strikes your swap at that price, and we are in business. If the shares go up, so does your swap, and the swap dealer remains perfectly hedged.

But remember this is a derivative contract — a special, sacred and non-Euclidean thing, floating free of the grubby world of actual shares — and the one thing we know about derivative contracts is that therefore they do not link directly through to a hedge. They reference 1000 hypothetical Shares, so it does not matter whether your swap dealer actually holds shares as a hedge — I mean, it will, but it doesn’t have to — or mis-hedges: it still has to pay you the return on 1000 Tesla shares.

As long as everything stays like that, all is fair in love and war. 100 Tesla shares represents a fixed portion of Tesla’s equity capital, and that is what you will get when your close out your positions.

But what happens if Tesla undergoes some corporate event — a share buyback, or a capital raise, or a share split, or it otherwise futzes with the portion of the company’s structure that a given share represents? The ground has moved beneath your original share swap.

For example, if Tesla announces a stock split where one existing share will become two — the value of each share halves, the number of shares doubles, and the swap dealer’s hedge of 100 Tesla Shares has become 200. But unless we adjust the swap in a corresponding way, it will still reference 100 shares, and will be half the original value. this would be to give the swap dealer an enormous windfall, which is not the idea of delta-one equity derivatives.

Hence the notion of “an event having a diluting or concentrative effect on the theoretical value of the relevant Shares”

We know this because we can see an disequilibrium between the swap and its hedge.