VOLUME 1, NUMBER 18/July 10, 1995
***************************************************************** DERIVATIVES 'R US is a weekly non-profit publication on the Internet user group misc.invest.futures that provides a simple non-technical treatment of various topics in derivatives. DRU is written by Don M. Chance, Professor of Finance at the Center for the Study of Futures and Options Markets at Virginia Tech. He can be contacted at dmc @ vt.edu or by phone at 703-231-5061 or fax at 703-231-4487. DRU is for educational purposes only and does not provide trading advice. Back issues of DRU available by anonymous ftp from fbox.vt.edu/filebox/business/finance/dmc/DRU or can be accessed using a Web browser at http://fbox.vt.edu:10021/business/finance/dmc/DRU. The file contents.txt can be viewed to see a list of old filenames and topics available for reading or downloading. *****************************************************************
EQUITY SWAPS
This weeks's topic is the third in a series of discussions on various types of swaps. Equity swaps are in my mind one of the greatest invention since the option. When the rest of the investment world finds out about them, things are going to get very interesting.
An equity swap is an agreement between two parties in which at least one party agrees to pay the other a return equal to the return on some type of equity index. The other party makes a payment that can be computed any other agreeable way. It could be on a floating rate or a fixed rate or based on another equity index. In other words, at least one payment has to be based on an equity index.
Suppose there is a portfolio manager who has a portfolio consisting of all U.S. equity. He decides (as more are doing nowadays) to diversify internationally by allocating twenty percent of his portfolio to foreign stocks. To keep things simple let's say he wants the foreign component to be exclusively German stock and primarily the stock of German blue chip companies. Of course, he could sell some domestic stock and buy foreign stock but this would be very expensive in terms of transaction costs. In addition, dealing with foreign stock can be extremely burdensome because of different legal systems, lack of information, different accounting conventions and in particular, the dividend withholding tax. The latter arises out of treaties between countries that permit a country to withhold a portion of the dividends in the event that the investor is liable for taxes. In some cases, these withheld dividends can be recovered but that does incur some additional costs.
The equity swap was primarily developed to deal with these problems in cross-country investing. Suppose our manager enters into a swap in which he agrees to pay the S&P 500 return to the swap dealer based on a notional principal equal to twenty percent of the market value of his portfolio. The dealer will pay him the return on the German index, the DAX, based on the same notional principal. He has, in effect, sold the U.S. stock and bought German stock. The payments can be made at any interval desired but quarterly would be common.
An important distinction, however, between equity swaps and interest rate swaps is that the equity return, unlike an interest rate, can be negative. Thus, if one market goes down and the other goes up, one party will be responsible for both sides of the payments. In general, equity swap payments will appear to be quite volatile but this reflects only the normal volatility of the markets. The same results would be obtained by trading the securities directly.
There are numerous ways to structure an equity swap. The notional principal can be fixed or variable. A fixed notional principal would replicate the position of a portfolio that is rebalanced periodically so as to maintain the same dollar allocation to a particular asset class. A variable notional principal would reflect a portfolio that is not rebalanced and grows or recedes due to normal changes in the relative market values of the asset classes.
In addition, an equity swap can be set up so that the party either absorbs or is hedged against the currency risk. For example, suppose our portfolio manager wanted only to participate in any growth in the German stock market but did not want to bear the currency risk. He would then structure the swap so that the payment is based on the DAX return applied to a dollar notional principal. If he wanted the currency risk, the payment would be based on mark notional principal though possibly converted into dollars at the current exchange rate before being paid to him. Then he would receive or make an additional payment to reflect the effect of the currency rate change on the notional principal. In other words, if the notional principal were DM20 million and the DAX went up 5 %, he would receive DM1 million, converted to dollars at the current exchange rate, less the payment he makes on the S&P 500. If, at the same time, the mark rose 1 percent against the dollar, he would receive an additional DM200,000. This would reflect the fact that he gained from both the German stock market and the German currency. Of course, he could lose either or both ways, as well.
Equity swaps can also be structured so that they are based on specific industries or market sectors, or even individual stocks, though the latter is not common.
Here's an extremely, albeit controversial use of an equity swap. The CEO of a firm called Autotote entered into a swap with Bankers Trust in which he agreed to pay BT the return on Autotote's stock based on 500,000 shares, which had a market value of about $13.4 million. The CEO also held 300,000 other shares, warrants to buy 500,000 other shares and options to buy 1.7 million shares but these were not covered in the swap. He will pay BT the dividends on these shares whenever those dividends are paid and any capital accrued at the end of the life of the swap. The CEO receives from BT some other return based on $13.4 million notional principal. My guess is that this return is a fixed rate or perhaps LIBOR.
The CEO, thus, effectively sold the shares to BT, yet he still retains title to the shares and hence (1) can still vote them - a matter of great significance to CEOs - and (2) does not have to pay taxes as if the stock were sold although he will have taxes on the income he receives from BT.
This transaction generated some controversy when the CEO reported it as an insider sale. My sources tell me that this type of transaction is going on unreported in some cases due to the smaller size of the transaction relative to the total number of shares owned by the executive and the uncertainty about whether it really is an insider sale.
In any case, financial engineering has clearly reached the corporate boardroom.