Cash Settlement - Equity Derivatives Provision

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2002 ISDA Equity Derivatives Definitions
A Jolly Contrarian owner’s manual™

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Resources About the Equity Derivatives Definitions | (full wikitext) | (nutshell wikitext)
Hot topics Synthetic Prime Brokerage Anatomy | The Triple Cocktail | Cancellation and Payment | Calculation Agent
TOC | 1 General Definitions | 2 Option Transactions | 3 Exercise of Options | 4 Forward Transactions | 5 Equity Swap Transactions | 6 Valuation | 7 Settlement | 8 Cash Settlement | 9 Physical Settlement | 10 Dividends | 11 Adjustments and Modifications | 12 Extraordinary Events · 12.8 Cancellation Amount · 12.9 Additional Disruption Events · 12.9 List of ADEs · 12.9(b) Consequences of ADEs | 13 Miscellaneous

Index: Click to expand:

Section 8 in a Nutshell
Use at your own risk, campers!

Article 8 Cash Settlement
8.1. Cash Settlement of Option Transactions. For each Exercise Date under a Cash-settled Option Transaction Seller will pay to Buyer any Option Cash Settlement Amount on the Cash Settlement Payment Date for all Options exercised on that Exercise Date.
8.2. “Option Cash Settlement Amount” means, for each Valuation Date:

(a) Index Option Transaction and Index Basket Option Transactions: For any Exercise Date, the number of exercised Options x Strike Price Differential x one unit of the Settlement Currency x any Multiplier; and
(b) Share Option Transaction and Share Basket Option Transactions: for any Exercise Date, the number of exercised Options x Option Entitlement x Strike Price Differential.

8.3. “Strike Price Differential” means, for each Valuation Date, the greater of zero and

(a) for a Call, Settlement Price - Strike Price; or
(b) for a Put, Strike Price - Settlement Price.

8.4. Cash Settlement of Forward Transactions. For each Cash Settlement Payment Date under a Cash-settled Forward Transaction:

(a) if “Prepayment” does not apply:
(i) where the Forward Cash Settlement Amount is positive, Seller will pay it to Buyer on the Cash Settlement Payment Date; and
(ii) if Forward Cash Settlement Amount is negative, then Buyer will pay its absolute value to Seller on the Cash Settlement Payment Date; and
(b) if “Prepayment” applies, Seller will pay Buyer Forward Cash Settlement Amount + any Excess Dividend Amount on the Cash Settlement Payment Date.

8.5. Forward Cash Settlement Amount. “Forward Cash Settlement Amount” means, for each Valuation Date:

(a) Index Forward Transaction or Index Basket Forward Transactions:
(i) where “Prepayment” does not apply: Settlement Price - Forward Price x 1 unit of Settlement Currency x Multiplier;
(ii) where “Prepayment” applies: Settlement Price x 1 unit of Settlement Currency x Multiplier;
(b) Share Forward Transaction or Share Basket Forward Transactions:
(i) where neither “Prepayment” or “Variable Obligation” applies: Number of Shares (or Baskets) x Settlement Price - Forward Price;
(ii) where “Prepayment” applies but “Variable Obligation” does not: Number of Shares or Baskets x Settlement Price;
(iii) where “Prepayment” does not apply but “Variable Obligation” does:
(A) where Settlement PriceForward Floor Price: Number of Shares or Baskets x Settlement Price - Forward Floor Price;
(B) where Forward Cap PriceSettlement Price > Forward Floor Price: Number of Shares or Baskets x zero; and
(C) where Settlement Price > Forward Cap Price: Number of Shares or Baskets x Settlement Price - Forward Cap Price; and
(iv) where both “Prepayment” and “Variable Obligation” apply: Number of Shares or Baskets (without rounding) x Settlement Price.

8.6. Cash Settlement of Equity Swap Transactions. Where Cash Settlement applies for each Cash Settlement Payment Date under an Equity Swap Transaction, if the Type of Return is:

8.6(a)Price Return”:
(i) if the Equity Amount is positive then the Equity Amount Payer will pay it (with any other amounts it owes) to the Equity Amount Receiver on the relevant Cash Settlement Payment Date; and
(ii) if the Equity Amount is negative then the Equity Amount Receiver will pay its absolute value (with any other amounts it owes) to the Equity Amount Payer on the relevant Cash Settlement Payment Date;
8.6(b)Total Return” and “Re-investment of Dividends” does not apply, then Price Return will apply, only on each Dividend Payment Date, the Equity Amount Payer will pay any due Dividend Amount to the Equity Amount Receiver on the Dividend Payment Date; and
8.6(c)Total Return” and “Re-investment of Dividends” applies, then Price Return will apply, only when determining each the Equity Amount on each later Cash Settlement Payment Date the Calculation Agent must adjust the Equity Notional Amount as described in Section 10.4.

8.7. The “Equity Amount” for any Cash Settlement Payment Date means Equity Notional Amount X Rate of Return as determined by the Calculation Agent at the Valuation Time on the Valuation Date.
8.8. “Cash Settlement Payment Date” means the date specified in Confirmation or, if none is specified, the date that is one Settlement Cycle following the Valuation Date, (or, in either case, the following Currency Business Day if the date in question isn’t one).

If, due to a Disrupted Day, there is more than one Valuation Date for the components of any Basket, the Cash Settlement Payment Date will be determined by reference to the last one.
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Full text of Section 8

Article 8 Cash Settlement
Section 8.1. Cash Settlement of Option Transactions. In respect of each Exercise Date under an Option Transaction for which “Cash Settlement” is applicable, Seller shall pay to Buyer the Option Cash Settlement Amount, if any, on the relevant Cash Settlement Payment Date for all Options exercised or deemed exercised on that Exercise Date.
Section 8.2. Option Cash Settlement Amount. “Option Cash Settlement Amount” means, unless otherwise provided in the related Confirmation, in respect of each Valuation Date:

(a) under an Index Option Transaction or Index Basket Option Transaction, an amount equal to the number of Options exercised or deemed exercised on the relevant Exercise Date multiplied by the Strike Price Differential multiplied by one unit of the Settlement Currency multiplied by the Multiplier, if any; and
(b) under a Share Option Transaction or Share Basket Option Transaction, an amount equal to the number of Options exercised or deemed exercised on the relevant Exercise Date multiplied by the Option Entitlement multiplied by the Strike Price Differential.

Section 8.3. Strike Price Differential. “Strike Price Differential” means, unless otherwise provided in the related Confirmation, in respect of each Valuation Date, an amount equal to the greater of (a) the excess of (i) in the case of a Call, the relevant Settlement Price over the Strike Price or (ii) in the case of a Put, the Strike Price over the relevant Settlement Price, and (b) zero.
Section 8.4. Cash Settlement of Forward Transactions. In respect of each Cash Settlement Payment Date under a Forward Transaction for which “Cash Settlement” is applicable:

(a) if “Prepayment” is not applicable:
(i) if the Forward Cash Settlement Amount is a positive number, then Seller shall pay to Buyer the Forward Cash Settlement Amount on the relevant Cash Settlement Payment Date; and
(ii) if the Forward Cash Settlement Amount is a negative number, then Buyer shall pay to Seller the absolute value of the Forward Cash Settlement Amount on the relevant Cash Settlement Payment Date; and
(b) if “Prepayment” is applicable, then Seller will pay to Buyer on the relevant Cash Settlement Payment Date the sum of the Forward Cash Settlement Amount and the Excess Dividend Amount, if any.

Section 8.5. Forward Cash Settlement Amount. “Forward Cash Settlement Amount” means, unless otherwise provided in the related Confirmation, in respect of each Valuation Date:

(a) under an Index Forward Transaction or Index Basket Forward Transaction to which “Prepayment” is not applicable, an amount equal to the Settlement Price minus the Forward Price multiplied by one unit of the Settlement Currency multiplied by the Multiplier, if any;
(b) under an Index Forward Transaction or Index Basket Forward Transaction to which “Prepayment” is applicable, an amount equal to the Settlement Price multiplied by one unit of the Settlement Currency multiplied by the Multiplier, if any;
(c) under a Share Forward Transaction or Share Basket Forward Transaction to which “Prepayment” is not applicable and “Variable Obligation” is not applicable, an amount equal to the Number of Shares or the Number of Baskets, as the case may be, multiplied by an amount equal to the Settlement Price minus the Forward Price;
(d) under a Share Forward Transaction or Share Basket Forward Transaction to which “Prepayment” is applicable and “Variable Obligation” is not applicable, an amount equal to the Number of Shares or the Number of Baskets, as the case may be, multiplied by the Settlement Price;
(e) under a Share Forward Transaction or Share Basket Forward Transaction to which “Prepayment” is not applicable and “Variable Obligation” is applicable, an amount equal to the Number of Shares or the Number of Baskets, as the case may be, multiplied by:
(i) if the Settlement Price is less than or equal to the Forward Floor Price, an amount equal to the Settlement Price minus the Forward Floor Price;
(ii) if the Settlement Price is greater than the Forward Floor Price but less than or equal to the Forward Cap Price, zero; and
(iii) if the Settlement Price is greater than the Forward Cap Price, an amount equal to the Settlement Price minus the Forward Cap Price; and
(f) under a Share Forward Transaction or Share Basket Forward Transaction to which both “Prepayment” and “Variable Obligation” are applicable, an amount equal to the Number of Shares to be Delivered or the Number of Baskets to be Delivered, as the case may be and in either case determined without regard to rounding, multiplied by the Settlement Price.

Section 8.6. Cash Settlement of Equity Swap Transactions. In respect of each Cash Settlement Payment Date for an Equity Amount Payer under an Equity Swap Transaction for which "Cash Settlement” is applicable:

8.6(a) if the Type of Return specified in the related Confirmation is “Price Return”, then:
(i) if the Equity Amount determined by the Calculation Agent in relation to that Equity Amount Payer is a positive number, then that Equity Amount Payer will pay (in addition to any other amounts payable by that Equity Amount Payer) to the Equity Amount Receiver the Equity Amount on the relevant Cash Settlement Payment Date; and
(ii) if the Equity Amount determined by the Calculation Agent in relation to that Equity Amount Payer is a negative number, then the Equity Amount Receiver will pay (in addition to any other amounts payable by that Equity Amount Receiver) to the Equity Amount Payer the absolute value of the Equity Amount on the relevant Cash Settlement Payment Date;
8.6(b) if the Type of Return specified in the related Confirmation is “Total Return” and “Re-investment of Dividends” is not applicable, then Section 8.6(a) will apply as though Price Return were the applicable Type of Return and, in addition, on each Dividend Payment Date, the relevant Equity Amount Payer will pay to the Equity Amount Receiver the relevant Dividend Amount (if any) owed by such Equity Amount Payer on that Dividend Payment Date; and
8.6(c) if the Type of Return specified in the related Confirmation is “Total Return” and “Re-investment of Dividends” is applicable, then Section 8.6(a) will apply as though Price Return were the applicable Type of Return, provided that for purposes of determining the relevant Equity Amount for each subsequent Cash Settlement Payment Date the Calculation Agent shall make the adjustment provided for in Section 10.4.

Section 8.7. Equity Amount. “Equity Amount” means, in respect of each Cash Settlement Payment Date and an Equity Amount Payer, an amount, determined by the Calculation Agent as of the Valuation Time on the Valuation Date to which the Cash Settlement Payment Date relates, equal to the product of the Equity Notional Amount and the Rate of Return.
Section 8.8. Cash Settlement Payment Date. “Cash Settlement Payment Date” means any date specified or otherwise determined as provided in the related Confirmation or, if any such date is not a Currency Business Day, the next following Currency Business Day. If no such date is specified in the related Confirmation, the Cash Settlement Payment Date will fall on the date that is one Settlement Cycle following the Valuation Date, or if such date is not a Currency Business Day, the next following Currency Business Day. In the case of an Index Basket Transaction or Share Basket Transaction, if as a result of the occurrence of a Disrupted Day there is more than one Valuation Date with respect to Indices or Shares comprised in the Basket, then the relevant Cash Settlement Payment Date shall be determined by reference to the Valuation Date which is the last to occur.
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Content and comparisons

8 Cash Settlement
Section 8.1 Cash Settlement of Option Transactions
Section 8.2 Option Cash Settlement Amount
Section 8.3 Strike Price Differential
Section 8.4 Cash Settlement of Forward Transactions
Section 8.5 Forward Cash Settlement Amount
Section 8.6 Cash Settlement of Equity Swap Transactions

8.6(a). Price Return
8.6(b). “Total Return” and “Re-investment of Dividends” is not applicable
8.6(c). “Total Return” and “Re-investment of Dividends” is applicable

Section 8.7 Equity Amount
Section 8.8 Cash Settlement Payment Date
Compare with Physical Settlement of Equity Swap Transactions under Section 9.3, which I am bound to say is a lot less fraught.
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Summary

A cash-settled slight return swap yesterday

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.

Section 8.6: Cash Settlement of Equity Swap Transactions

Equity Swap Transactions can be settled either by reference to Price Return or Total Return, but not slight return.

Section 8.6, Cash Settlement of Equity Swap Transactions, provides, more or less, that where “Cash Settlement” applies, a payment is made on each Cash Settlement Payment Date depending on the Type of Return specified.

Section 8.7: Equity Amount

Equity Amounts, then. Straightforward enough: Take your Equity Notional Amount — helpfully filled out in the Confirmation — multiply it by the Rate of Return, being the performance of the underlying share over the period in question — and there’s your number.

Let’s put some numbers on this, because, as with many of the finer creations of ISDA’s crack drafting squad™, there is quite a lot of buried technology in there to unpack.

The first component is the Rate of Return. This is a calculation of the performance of the Share over the period, times a Multiplier which might apply if you are doing some kind of kooky leveraged trade, but more likely will account for capital gains or stamp duty payable by the broker on the underlying hedge — so you might expect something like 85%. But that makes the mathematics too complicated for this old fellow, so let’s call the Multiplier 100%, so you can ignore it, and say the Initial Price is 100. And let’s do two scenarios: where the stock has gone up — here say the Final Price is 105, and where the stock has gone down — here, say the Final Price is 95.

The Rate of Return formula is (Final Price - Initial Price)/Initial Price) * Multiplier, which works out as:

  • Where the stock went up: (105-100)/100 * 100% = 5/100 = +5%.
  • Where the stock went down: (95-100)/100 * 100% = -5/100 = -5%.

Now to calculate your Equity Amount, we take the Equity Notional Amount (for ease of calculation, say USD1,000,000?) and times it by the Rate of Return:

  • Where the stock went up: USD1,000,000 * +5% = USD+50,000.
  • Where the stock went down: USD1,000,000 * -5% = USD-50,000.

Section 8.8: Cash Settlement Payment Date

A provision that does very little to help an inquiring mind with the question “What is the Cash Settlement Payment Date actually, like, for?”

For that, you would be advised to consult Section 8.6, Cash Settlement of Equity Swap Transactions, which differentiates between “Price Return”, which concerns itself purely with the prevailing equity price of the underlier, and “Total Return” which also factors in dividends paid on the relevant stock, and “slight return”, which is a Jimi Hendrix song.[1]

Note: Dividend Amounts are typically payable on the Cash Settlement Payment Date — though the Cash Settlement Payment Date following what — that is the question, whose answer, it turns out, is a little bit odd, as you will see if you investigate further.
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General discussion

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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See also

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References


  1. It doesn’t really relate to slight return, though that is a Jimi Hendrix song.