Equity Swap Transactions - Equity Derivatives Provision
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2002 ISDA Equity Derivatives Definitions Section 5 in a Nutshell™ Use at your own risk, campers!
Full text of Section 5
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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
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).
General discussion
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 a function of the fact that Share Basket Forwards behave differently to Basket Swaps, or just because the drafting committee was losing the will to live, is a question to which we have yet to get to the bottom.
Don’t hold your breath.
Where share Final Price is determined by reference to the Volume Weighted Average Price during a trading session you may see this following amendment:
- (a) Section 6.3(a) is amended by deleting “at any time during the one hour period that ends at the relevant Valuation Time, Latest Exercise Time, Knock-in Valuation Time or Knock-out Valuation Time, as the case may be” and replacing it with “at any time during the regular trading session on the Exchange, without regard to after hours or any other trading outside of the regular trading session hours”.
- (b) Section 6.3(d) is amended by deleting the remainder of the provision following the term “Scheduled Closing Time” in the fourth line thereof;
- (c) If the final Valuation Date is a Disrupted Day, the Calculation Agent may determine that such day is a Disrupted Day only in part, in which case the Calculation Agent must designate the Valuation Date determined pursuant to Section 6.6(a) for the remaining portion and the Calculation Agent must adjust the Number of Shares for which the Disrupted Day is the Valuation Date and must determine the Final Price based on such adjustments which will be based on such factors as the Calculation Agent considers relevant.
The current US tax interpretation is that benchmarking an equity swap on a US Share to the close is viewed a cross (and one is guilty until proven innocent). Therefore, do not use the official closing price for US Shares at maturity as it would then invalidate them as true derivatives and recharacterise them as repos. Instead, confirm VWAP over the day as an observable benchmark price for termination.
This does not, however, prevent one early-terminating an Equity Swap Transaction on a US Share using methods other than VWAP. Now, if you are a synthetic prime brokerage sort of camper, you might wonder why all this fuss as equity swaps are treated, for most purposes, as undated and are always terminated at the client’s motion as an optional early termination.
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.
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
- ↑ 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.