Valuation Time - Equity Derivatives Provision
2002 ISDA Equity Derivatives Definitions
Section 6.1 in a Nutshell™
Use at your own risk, campers!
Full text of Section 6.1
Content and comparisons
Article 6. Valuation
Section 6.1. Valuation Time
Section 6.2. Valuation Date
Section 6.3. General Terms Relating to Market Disruption Events
- 6.3(a) Market Disruption Event
- 6.3(b) Trading Disruption
- 6.3(c) Exchange Disruption
- 6.3(d) Early Closure
Section 6.4. Disrupted Day
Section 6.5. Scheduled Valuation Date
Section 6.6. Consequences of Disrupted Days
Section 6.7. Averaging
- 6.7(a). Averaging Date
- 6.7(b). Settlement Price and Final Price
- 6.7(c). Averaging Date Disruption
- 6.7(d). Adjustments of the Exchange-traded Contract
- 6.7(e). Adjustments to Indices (Averaging)
Section 6.8. Futures Price Valuation
- 6.8(a) Valuation Date (Futures Price Valuation)
- 6.8(b) Additional definitions (Futures Price Valuation)
- 6.8(c) Settlement Price and Final Price (Futures Price Valuation)
- 6.8(d) Adjustments of the Exchange-traded Contract (Futures Price Valuation)
- 6.8(e) Non-Commencement or Discontinuance of the Exchange-traded Contract
- 6.8(f) Corrections of the Official Settlement Price
For run-of-the-mill valuations not related to the termination of a Transaction, the fall-back Scheduled Closing Time regime is fine.
The effect of the Valuation Date is to re-strike the Equity Notional Amount (or cash settle the movement in the underlier since the last Valuation Date which is economically similar to a variation margin payment.
For the final Valuation Date, on the other hand - which feeds into the actual termination price for the Transaction, expect the broker to be more exercised about the timing matching the point at which it liquidates its actual Hedge Position. Expect jumpier US tax folk to start rabbiting on about hypothetical broker-dealers liquidating hypothetical hedges, but have no truck with that sort of talk.
In some jurisdictions, derivatives are taxed differently — more favourably — than cash equities (for example stamp duty reserve tax, and in the US, for certain types of underlier, under 871(m)) so it is important that your synthetic position doesn’t look like a tax play. Tax attorneys — especially American ones — fret mightily that high-delta equity derivatives do.
One of the key indicators, they intuit, is the degree to which the contract permits a swap counterparty influence or control its prime broker’s hedge. A swap counterparty should care not one whit about its broker’s hedge — other than its cost. If it does takes an unhealthy interest, the swap position may be — dramatic look gopher — recharacterised as a disguised custody arrangement of shares the swap counterparty has in reality bought, and on which it should pay tax, stamp duty and so on. Depending on which tax specialist you ask, an “unhealthy interest” might extend even to the execution price the broker-dealer achieves on its hedge. (This seems potty to us, by the way, but such is the interior world of the US tax attorney). US tax attorneys are greatly calmed by the suggestion that a hedge execution price is imaginary, and not real, even though it happens to be identical to the real one. Thus, you will see much chatter about prices a “hypothetical broker-dealer” might achieve selling fungible securities, and volume-weighted average prices and so on.
What is a hypothetical broker-dealer anyway?
So who, why, which or what is this much-talked-about, seldom-seen “hypothetical broker-dealer”?
Well, it’s an investment banker’s imaginary friend. A fellow just like the actual broker-dealer — in the same jurisdiction, having the same taxation status, earning the same income, executing the same hedge transactions, eating at the same restaurants, having the same GSOH and watching the same stuff on Netflix — but not the actual broker-dealer. He’s like actual broker-dealer’s “sober me”, only he gets drunk too. Now this might strike you, as it strikes the JC, as just too cute – too much of a playground argument to hold water. (“I didn’t break the window, sir, honest, sir, it was a boy who looked exactly like me who arrived from out of nowhere and is gone now”). But US tax attorneys seem to be taken in by it, even if they won’t buy arguments on actual economic substance.
But do synthetic equity swaps resemble disguised custody arrangements?
Um — no. About the economic substance: synthetic equity swaps don’t resemble disguised custody arrangements at all:
- (i) a prime broker will hedge delta-one across its whole client portfolio — some of which will be short, and some long — so there is no one-to-one relationship between each client’s long position and the prime broker’s net physical hedge in the first place — that is to say, there is no assurance that the prime broker is holding anything in custody at any time; and
- (ii) even if there were, the prime broker will almost certainly finance the net long portion of its delta anyway, to reduce its funding costs, by lending it out, title transfer, for cash, so even if the prime broker has a corresponding exposure, it won’t be hedging it with holding a physical hedge at all, let alone one it is covertly holding on custody for its clients.
But US tax attorneys wilfully ignore all this dispiriting logical talk and insist the only thing that can save you are some magic words about you hedge costs being incurred by a hypothetical broker dealer exactly like you, but who isn’t you.
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- ↑ I.e., Final Price - Initial Price.