Template:Equity derivative charging: Difference between revisions

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 Remember our theory of the game, [[synthetic PB]] ninjas: ''[[synthetic PB]] is just [[margin lending]] done with swaps''. That should offer some clues about how clients ''pay'' for it. The economics are the same. This is about the economic cost of entering margin loans, not the economic exposure you have to the stock you have bought. Though that does come into it.
-===Costing of physical [[prime brokerage]]===
+==Physical [[prime brokerage]]==
+[[File:PB margin loans.png|300px|frameless|left]]
+===Physical longs===
 In a physical [[margin loan]] — representing a ''[[long]]'' equity position — the client expects two types of cost:
 *'''[[Financing]]''': The financing costs it will incur from its prime broker in borrowing the money it needs to buy the stock, and
 *'''[[Commission]]''': The [[brokerage]] [[commission]]s it will incur from its equity broker in buying (and when it is ready to, selling again) the stock.
-:To offset its costs, the [[prime broker]] can [[rehypothecate]] the stock, which it holds in custody for the client. Now when it does so, the [[PB]] does not take ''[[price risk]]'' to the stock: remember; it does not have a directional view on the stock. So it will not sell the stock outright, but more likely 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 for all concerned: the [[PB]] will receive more cash, and at the limit may reach its rehypothecation limit and have to return some of the rehypothecated stock to the client. If the stock declines in value, the [[PB]] will be able to raise less cash against it, but will be able to call for more margin from the client.
+To offset its costs, the [[prime broker]] can [[rehypothecate]] the stock, which it holds in custody for the client. Now when it does so, the [[PB]] does not take ''[[price risk]]'' to the stock: remember; it does not have a directional view on the stock. So it will not sell the stock outright, but more likely 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 for all concerned: the [[PB]] will receive more cash, and at the limit may reach its rehypothecation limit and have to return some of the rehypothecated stock to the client. If the stock declines in value, the [[PB]] will be able to raise less cash against it, but will be able to call for more margin from the client.
+[[File:PB stock loans.png|300px|frameless|left]]
-In a ''[[short]]'' position on margin, the client expects the following costs:
+===Physical shorts===
+In a ''[[short]]'' position on margin, the [[client]] expects the following costs:
 *'''[[Financing]]''': The financing costs it will incur from its [[prime broker]] under the [[stock loan]] by which it borrows the security it wants to short, and
 *'''[[Commission]]''': The [[brokerage]] [[commission]]s it will incur from its equity broker in selling (and when it is ready to, buying back) the stock it has borrowed.
-:Here the client also has something it can offer the prime broker to offset its internal funding costs: the proceeds of sale of the borrowed stock, which it banks in its cash account with the [[PB]]. That has the effect or reducing its overall indebtedness. Now its exposure moves around under the [[stock loan]] with the [[prime broker]]. If the stock increases in value, the client’s liability under the [[stock loan]] also increases, and the [[PB]] will call for margin. If the stock decreases in value, happy days for all concerned: the [[PB]] will receive more cash, and at the limit may reach its rehypothecation limit and have to return some of the rehypothecated stock to the client. If the stock declines in value, the [[PB]] will be able to raise less cash against it, but will be able to call for more margin from the client.
+Here the client also has something it can offer the prime broker to offset its internal funding costs: the proceeds of sale of the borrowed stock, which it banks in its cash account with the [[PB]]. That has the effect of reducing the [[client]]’s overall indebtedness. Now its exposure moves around under the [[stock loan]] with the [[prime broker]]. If the stock increases in value, the client’s liability under the [[stock loan]] also increases, and the [[PB]] will call for margin. If the stock decreases in value, happy days for the client: the value of its stock loan liability (to return that stock to the [[PB]]) will decline, meaning its overall indebtedness declines meaning at the limit the [[PB]] may reach its rehypothecation limit and have to return some of the rehypothecated stock to the client.
-===Costing of [[synthetic prime brokerage]]===
+==[[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:
+[[File:PB long swap.png|300px|frameless|left]]
-===Long equity swap===
+===Synthetic longs===
+In a ''long'' [[synthetic equity swap]] — the synthetic equivalent of a physical long, of course — the client expects two types of cost:
-===Short equity swap===
+*'''[[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]].
+[[File:PB short swap.png|300px|frameless|left]]
+===Synthetic shorts===
+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.