Dilution or Concentration Event - Equity Derivatives Provision
|Equity Derivatives Anatomy™|
There is no such definition in the 2002 ISDA Equity Derivatives Definitions, but there should be, for variations on the unwieldy phrase “a diluting or concentrative effect on the theoretical value of the relevant Shares” appear seven times.
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 the value of 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 grotesque world of actual shares which can sometimes do unpredictable things, in the cut-and-thrust of capital markets, corporate intrigue, hostile takeovers and so on. The one thing we know about derivative contracts generally, and equity swaps in particular, is that they do not correspond directly to a hedge. There is a miasma; an invisible, but impermeable membrane between them: equity derivatives are an idea. They are of the spheres. Equities are a reality. They are of the wet earth and the cave.
The Corinthian ideal of your 1000 hypothetical Tesla shares floats free of whatever mendacity or crapulousness your swap dealer visits on its earthly hedge. Indeed, it does not matter whether your swap dealer even has a hedge — I mean, it will, but it doesn’t have to — or mis-hedges: it must still pay you the return on those glistening, ethereal 1000 Tesla shares.
Now as long as everything stays like that, all is fair in love and war. 1000 Tesla shares represents a fixed portion of Tesla’s equity capital, and that is the return you will get when your close out your position: your swap dealer will liquidate its hedge — or look up in the financial pages to see what the most recent closing price was — and that will be your price.
But love and war in the international capital markets is not fair. It is bananas. All kinds of chicanery goes on. Our carefully constructured Platonic ideal might come apart if Tesla undertakes some corporate action — 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”. These are the provisions of the 2002 ISDA Equity Derivatives Definitions that guide what the Calculation Agent can and cannot do in response.
- Or there’s a give in or whatever.
- perhaps it is the other way around: the equities are platonic ideals, the swaps their flickering, misshapen shadows rendered against the craggy, mildewed walls of the cavernous swaps market to whose walls we practitioners are permanently chained. I don’t know. That seems a bit miserable.
- I mean in terms of mishedging, or not hedging. If the dealer remains perfectly hedged, then the crapulousness of the market, funding and hedging conditions remains the customer’s problem.