Equity derivative
Step this way into the world of synthetic equity swaps, contract for differences, and all the manifold and beautiful ways you 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 Equity Derivatives Definitions, so the place you should immediately visit is the JC’s Equity Derivatives Anatomy.
“High delta” equity derivatives that replicate, one-for-one, the economic effect of cash equities trading are often called “synthetic equity swaps” or “synthetic prime brokerage”.
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.
Format
In a broader sense, equity derivatives come in many shapes and sizes: swaps, contracts for difference, exchange-traded derivatives, or structured products. Here we are mostly talking about OTC contracts documented under an ISDA Master Agreement, as these are the commonest and most heavily negotiated formats of the contract, and they show up in the main use cases: as plain OTC contracts in synthetic prime brokerage and strategic equity, and as the hedge component of equity-linked notes. There is a fair bit of background material relating to basic economic concepts which will be of some use in other formats, too.
Transactions
In the ISDA universe, Transaction types break down into swaps, options and forwards. These run the gamut of “use cases”: broadly, swaps give the customer two-way exposure to “Underliers” — the customer can make or lose money, depending on whether the Underlier goes down or up (and whether the customer is short or long) — options give the customer one-sided exposure to the Underlier, without the risk of a loss should things go badly, against payment of a premium, and forwards are mainly financing tools, where the customer keeps its equity exposure but raises money against its positions, therefore managing its balance sheet and borrowing costs.
Underliers
One can write swaps, options and forwards on a Share, on a Basket of Shares, on an Index, and a Basket of Indices. The difference between Baskets of Shares and Indices is subtle but we will get on to that later.
Features
As an instrument class, Shares are markedly more variable than fixed-income: they don’t have a “principal amount” or notional amount as such (their par value is meaningless), they don’t have a term, do not redeem, and don’t really “default”: any price they trade at above zero is a fair price, and depending entirely on market consensus on the performance and prospects of the Share issuer’s underlying business.
Whereas fixed-income instrument values oscillate around their principal amount a bit, driven mainly by interest accrual considerations and (at the limit) by catastrophic credit deterioration, Share values fly all over the place, depending by all kinds of considerations it is generally quite hard to parse.
Shares also can’t “default” as such. While a debt instrument that repays at any price below its stated redemption value is in default and represents a fundamental breach of contract for a Share, any price above zero is a good price; even a price of zero (which implies bankruptcy) does not necessarily confer any legal redress against the Share issuer.
Since there is no principal amount, the yardstick by which one measures equity derivatives is their purchase and sale price. : The price at which one enters, or strikes, a Transaction is the “Strike Price” (or the “Initial Price”); the price at which you value it and exit from it thereafter is the “Final Price”.
Key concepts
Strike Price: the market price of the Underlier at the Trade Date.
Settlement Price: the market price of the Underlier at the Termination Date.
Barrier: The point above or below which a Transaction may knock in, knock out, or a 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).
Users and dealers
Interesting metaphor huh? Always bear in mind in an equity derivative that there is a dealer and an end user and they have quite different perspectives. The dealer is interested only in commission and financing spread; the end-user wants the actual exposure provided by the equity derivative. Therefore the dealer is delta-hedging, and will be extremely sensitive to market events that happen which mean it can’t delta-hedge. These come in the shape of 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) and Hedging Disruption — where the market is functioning, kind of, but for some reason there are impediments to efficiently or legally hedging an exposure under an equity derivative.
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