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Equity Swaps

The mechanics of equity swaps. Understand the general mechanics of total return swaps, how to calculate equity swap leg payments, and the accrual method used in equity swap valuation.

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7 Lessons (29m)

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  • Description & Objectives

  • 1. Introduction to Equity Swaps

    04:55
  • 2. Variable vs. Fixed Notional

    07:27
  • 3. Long Equity Swap – Cash Flows

    04:38
  • 4. Short Equity Swap - Cash Flows

    03:59
  • 5. Equity Swap Valuation

    03:09
  • 6. Equity Swap Advantages and Disadvantages

    04:36
  • 7. Equity Swaps Tryout


Prev: Equity Index Futures

Long Equity Swap – Cash Flows

  • Notes
  • Questions
  • Transcript
  • 04:38

An example of a long equity swap.

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Transcript

Let's take a closer look at equity swap mechanics, focusing on the determination of the initial price and the detailed explanation of the financing leg. To start, let's consider the opening of the trade. Let's say a hedge fund wants long exposure to Walmart, but without buying the physical shares. To do this, they want to execute the trade via an equity swap. The hedge fund submits an order to their prime broker or PB to buy 75,000 shares of Walmart on swap. The financing rate agreed for the swap is SOFR plus 40 basis points, which reflects the prime broker's cost of capital and a small margin for facilitating the transaction.

There are different methods for determining the opening price of the swap, but for this example, let's say the parties agreed to use the actual execution price, which was 93.55.

The prime broker's trader would then purchase 75,000 Walmart shares in the market to hedge the trade, and this actual execution price becomes the opening price of the swap. The total notional value of the swap is calculated by multiplying the share price by the number of shares, which comes to 7,016,250.

This notional value forms the basis for all subsequent cash flows in the swap.

It's worth noting that the initial price may vary slightly due to factors such as liquidity conditions or the size of the order.

Now let's move to the closing of the trade, and we assume that the hedge fund decides to exit the position after 22 days.

When the hedge fund decides to exit the position, the prime broker sells the shares in the markets and the hedge fund's profit or loss on the trade is determined by the difference between the opening and closing prices.

Suppose the closing share price is 95.25.

This price is higher than the opening price of 93.55 resulting in a gain.

The share price increased by 1.7 per share and multiplying this by the 75,000 shares, the total gain on the trade is 127,500.

Now that we've calculated the profit from the trade, let's turn to the financing costs, which are an integral part of the swaps economics as it represents the carrying charge for maintaining the position over its duration.

The financing cost is determined using the agreed floating rate, which in this case is going to be SOFR plus 0.4%. In our example, the swap position is closed after 22 days, and let's say the compounded SOFR rate over this period is 5.1% expressed on an annual basis.

Adding the 0.4% spread brings the total annualized rate to 5.5%.

To calculate the interest cost the notional value of 7,016,250. That needs to be multiplied by the 5.5% total interest rates de-annualized for the 22 days the swap was open, i.e. multiplying by 22 over 360. And this results in a financing cost of approximately 23,582, which the hedge fund owes to the prime broker.

Finally, we calculate the hedge fund's net result by combining the gain from the price increase with the financing cost, subtracting the financing cost of 23,582 from the gain of 127,500. Their hedge funds net profit amounts to 103,918.

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