Equity Swap - Accounting
1. Learning Objectives
- Gain an understanding of the three primary components of equity swaps.
- Recognize distinctive features of equity swaps.
- Comprehend the motivations behind investors engaging in equity swap transactions.
2. Content
An equity swap is an over-the-counter (OTC) derivative where two parties exchange cash flows. One cash flow mirrors the performance of a commonly traded stock, while the other represents interest. Cash changes hands solely at the contract's closure, either during a sale or a cover transaction, which is a characteristic shared with most derivatives.
2.1. Three Profit/Loss Components of an Equity Swap
2.1.1. Equity Leg
This component reflects the performance of the underlying stock.
2.1.2. Interest Leg or Financing Leg
This component signifies the interest payment the "long" side of the contract pays to the "short" side in return for benefiting from the stock's performance. Consequently, the "long" side is termed the "floating rate payer" in the swap contract documents.
2.1.3. Dividend Leg
In equity swaps, all rights and obligations of the underlying stock concerning corporate actions remain applicable. Consequently, the "long" side of the contract receives any eligible dividends, with the issuing company not directly disbursing these dividends. Instead, the "short" side of the contract must remit any declared dividends to the "long" side.
2.2. Other Terms of an Equity Swap
2.2.1. Notional
An equity swap contract doesn't entail an actual cost. The trade doesn't involve cash initially but instead relies on an "underlying cost," termed the "notional" amount. This notional amount serves as the basis for calculating the interest component of the equity swap and represents the principal amount for interest calculation.
2.2.2. Resets
Equity swap contracts typically span three months, but cash flows don't wait for this duration. The contract incorporates preset cash flow dates during these three months, referred to as "reset dates." These resets may occur weekly or monthly, enabling the calculation of net profit or loss (P/L) at each reset date.
2.2.3. Valuation Date (NAV Date)
Valuation occurs on this date. Although it doesn't involve cash flows, it does consider unrealized equity P/L and accruals for interest and dividends, incorporating all three P/L components of the equity swap.
2.2.4. Dividends
Since dividends aren't paid directly by the company in equity swaps (the "short" side handles this), dividends are paid on the first reset date following the ex-date. This approach streamlines administration by consolidating cash flows of all three P/L components simultaneously. Notably, typical withholding taxes don't apply to equity swaps, as no shares are traded on a stock exchange.
2.3. Reasons for Investors to Use Equity Swaps
2.3.1. Leverage
Hedge funds frequently employ equity swaps for leverage since they involve no upfront cost. This absence of cost translates to a higher rate of return compared to actual stock trading.
2.3.2. Illiquid Markets
In situations where a hedge fund aims to trade a substantial volume of shares in a thinly traded market, equity swap contracts offer an effective solution, avoiding the potential market impact of large buy orders.
2.3.3. Currency Risk Mitigation
Trading foreign stocks exposes investors to currency risk, typically hedged through forward contracts. Equity swaps, being OTC instruments, provide flexibility in transaction currency, eliminating the need for additional currency hedges.
2.4. Trading an Equity Swap
Let's explore an example involving a long equity swap for the purchase of 10,000 shares of IBM US. The equity swap's mechanics, including reset calculations and valuation, illustrate how the contract evolves and generates net cash flows on settlement dates.
Trading an Equity Swap:
For example, suppose a fund intends to buy 10,000 shares of IBM US at $75.00 per share via an equity swap contract expiring in one month with weekly reset dates. The transaction unfolds as follows:
Contract Opening (Trade Date: 12th, Settlement Date: 15th): Purchase 10,000 shares, creating a notional of $750,000. No cash changes hands.
Reset Date #1 (Trade Date: 19th, Settlement Date: 22nd): Cash is exchanged, with IBM's price rising to $75.50. Profit from equity leg: $5,000; Interest payment: $776.72. No dividend applicable.
Reset Date #2 (Trade Date: 26th, Settlement Date: 29th): IBM's price falls to $75.25. Equity loss: $2,500; Interest payment: $810.85. No dividend applicable.
Valuation Date (NAV Date: 30th): IBM's price rises to $76.00. Unrealized equity gain: $7,500; Accrued interest: $116.49. No dividend applicable.
Reset Date #3 (Trade Date: 3rd, Settlement Date: 5th): IBM's price increases to $76.30. Equity gain: $10,500; Interest payment: $815.38. No dividend applicable.
Reset Date #4 (Trade Date: 14th, Settlement Date: 21st): IBM's price drops to $76.10. Equity loss: $2,000; Interest payment: $834.08; Dividend received: $3,000.
The net cash flows on the fund's prime broker account are tracked throughout these events, reflecting the gains and losses associated with the equity swap.
