Step this way into the world of synthetic equity swaps, contract for differences, and all the manifold and beautiful ways uyou can take on, or lay off, exposure to a share or a basket without actually buying it. An equity derivative is a contract that references the performance of shares and share indices. They are most usually documented under 2002 ISDA Equity Derivatives Definitions, so the place you should immediately visit is the JC’s Equity Derivatives Anatomy.
The starting assumption is that the underlying share already exists in the market: equity derivatives are a creature of the secondary market. So there’s not a lot of chat here about initial public offerings, subscription agreements and all that sort of thing. So the sorts of rights an initial subscriber might have (the Hedging Party) won’t automatically translate through to the holder of a synthetic exposure under an equity derivative.
Types of equity derivative
- Equity swap contracts, which are generally total return swaps and related index swap contracts
- Option contracts
- Forward contracts
- Synthetic prime brokerage: delta-one exposure; a swap version of pure share brokerage.
Equity derivatives reference the performance of the underlier over the term of the Transaction: The “Final Price”) is divided by the “Strike Price” (also known as “Initial Price”) to yield a percentage.
- A percentage of greater than 100% implies a positive return during Transaction.
- A percentage of less than 100% implies a negative return. You’re out-of-the-money, soldier.
- Strike Price: the market price of the underlier at the Trade Date;
- Settlement Price: the market price of the underlier at the Termination Date;
- Barriers: above or below which the trade may knock in, knock out, or the settlement formula may adjust;
- Valuation: on the Settlement Date, the Settlement Price will be determined by reference to one or more Valuation Dates, (if more than one, Averaging may apply).
Market and Hedging disruption
- Market Disruption: Contingency plans need to be made for what to do where it is not possible to make a valuation on any day on which one might be required (these may occur periodically through the transaction, and may be daily).
- Hedging Disruption: where the market is finctioning, but for some reason there are impediments to efficiently or legally hedging an exposure under an equity derivative.