Equity Swap Valuation
- 03:09
Explaining how an equity swap is valued using the accrual method, equity leg and financing leg.
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Glossary
Equity Swap ValuationTranscript
Let's explore how equity swaps are valued with a particular focus on the accrual method, which is most commonly used for standard equity swaps. In many cases, equity swaps are hedged with a position in the underlying equity. For example, if a client is long the equity leg of the swap, the broker often hedges this exposure by holding the equivalent number of shares. Conversely, for a short position, the broker would hedge by short selling the underlying shares.
This close connection between the swap and its underlying position influences the way equity swaps are valued.
Unlike other derivatives, which typically use a net present value or NPV approach to calculate their current value, equity swaps are generally marked to market using the accrual method. This is because users of equity swaps often treat them as cash equivalent positions and hedges. Managing these swaps generally rely on real-time cash market positions to mirror the swaps performance. This backward looking approach aligns seamlessly with the mechanics of the markets and the way hedgers manage risks. Here's how the accrual method works. Each day the equity leg reflects the performance of the underlying equity position, capturing both price movements and any dividends. For instance, if the equity leg gains 1% over a day, that value is added to the equity leg. Simultaneously, on the financing side, one day of accrued interest is added. The financing leg reflects the daily cost of funding or borrowing, and is based on the agreed floating rate, plus or minus any applicable spread. The sum of the two legs, the equity leg and the financing leg, gives the current mark-to-market value of the equity swap.
This transparency makes the accrual method particularly well suited for equity swaps where simplicity and alignment with market movements are key priorities for both users and hedgers. It provides a transparent and straightforward valuation that matches the actual economic exposure of the swap and the hedge.
For more structured equity swaps with complex terms such as those involving optionality or embedded features, an NPV method may sometimes be preferred. Unlike the accrual method, the NPV approach calculates the present value of expected future cash flows discounted to reflect the time value of money.