Template:Equity derivative charging: Difference between revisions

==[[Synthetic prime brokerage]]==

Under an [[equity swap]], the client never actually buys the stock, but it puts on a {{isdaprov|Transaction}} with its prime broker that replicates the economics of doing so, on margin:

In a ''long'' [[synthetic equity swap]] — the synthetic equivalent of a physical long, of course — the client expects two types of cost:  

*'''[[Financing]]''': The financing costs its swap dealer incurs in borrowing the money it needs to buy its [[Hedge Position - Equity Derivatives Provision|hedge position]], and

*'''[[Commission]]''': The equivalent of [[brokerage]] [[commission]]s it would pay its dealer for executing the trade (and when it is ready to, terminating it).

To offset its costs, the [[swap dealer]] can raise finance against its [[Hedge Position - Equity Derivatives Provision|Hedge Position]], which it owns outright, in the repo/stock loan market. since the stock hedges its swap position, the [[dealer]] will not sell the stock outright, but  will use it as collateral in the market, to raise cash (under a [[repo]]) or high-quality assets (under a stock loan). If the stock increases in value, happy days: the [[dealer]] will get more cash, but will need that for [[variation margin]] it owes its client to the swap. If the stock declines in value, the [[dealer]] will be able to raise less cash against it, but will be able to call for more [[variation margin]] from the [[client]].

In a ''short'' [[synthetic equity swap]] — the synthetic equivalent of a physical short, of course — the [[client]] expects the following costs:

*'''[[Financing]]''': The financing costs the swap dealer incurs under the [[stock loan]] the dealer executes as a [[Hedge Position - Equity Derivatives Provision|Hedge Position]] to the short swap, under which it borrows the physical underlying security and sells it short, and

*'''[[Commission]]''': The equivalent of [[brokerage]] [[commission]]s it would pay its dealer for executing the trade (and when it is ready to, terminating it).

:Here the [[dealer]] obtains the proceeds of short sale of its [[Hedge Position - Equity Derivatives Provision|Hedge Position]] and it can use these to offset its internal funding costs of collateralising its stock loan hedge.  Now ther client’s exposure under the short swap tracks the swap dealer’s exposure under the [[stock loan]] [[Hedge Position - Equity Derivatives Provision|Hedge Position]]: If the underlier increases in value, the client’s liability under the short and the dealer’s liability under its [[stock loan]] hedge increase, and the [[dealer]] will call the client for [[variation margin]], which it can use to meet its margin call on its hedge. If the stock decreases in value, happy days: the [[dealer]] will receive collateral back from its [[stock loan]] hedge counterparty, but will have to pay out [[variation margin]] to the client.