Hi,
Why would an equity return payer benefit when the market goes down?
Investor holds stocks which are within particular equity index.
To protect the position, he entered into an equity swap as fixed rate receiver, thus equity index yield payer. Fixed swap rate 8 % f.ex.
1 Year later stocks declined - 5 % as well as equity index.
Investor’s P/L
loss in stocks - 5 %
gain on swap 8 % - (- 5 ) = 13 %
Total 8 % gain on portfolio.
By entering into an equity swap an investor transferred equity market risk to a swap counterparty.
This is a simple example. But this was the point.
so the person who holds the stock or stock portfolio or equity index is receiving Libor and giving equity return to the Libor giver?
Also I still didn’t understand how the equity holder gains when the market is down.
Fixed rate payer is an equity return receiver and vice versa in an equity swap.
Person with an equity portfolio might use swap to hedge an equity return as fixed swap rate receiver in such case. In the event of stock market returns downfall, the hedged position will mitigate negative equity return. Total return of hedged portfolio might even be positive like in sample above if fixed receiver is short side of negative equity index return in equity swap. Long swap side means +, short side has prefix minus which becomes a positive value in the event of shorting negative return (losses).
Still don’t get it. Why? and How?
Tjhis is how I understand the swaps, at least in simplistic terms… maybe some pieces aren’t as accurate:
There’s two parties to the swap. One is the equity return payer and the other could be a fixed libor payor or floating libor payer, or really anything they want to be.
For the exam, its usually a fixed payer… So if you have a fixed payer, they are receiving equity return… and then equity return payer is receiving fixed swap rate. Let’s say the fixed rate is 5% annually andt he swap is quarterly… So each quarter the fixed rate payer is paying 1.25% of the notation… And in return, they recieve the equity index changes. If the index goes up by more than 1.25% for the quarter, they just made some money… If it goes less than 1.25% the net return is negative.
The equity payer is receiving the fixed rate of 5% annually (1.25% per quarter). If the index goes up more than 1.25%, they are pay more than they are receiving. If the index goes up by less than 1.25% or drops, they are making money. If the index drops by 1.25%, then they receive 1.25% from the fixed rate swap and they pay negative 1.25% on the equity which in total is 2.5% gain for the quarter. The equity payer wants to equity index to drop!
With the swap, they’ll experience a positive return.
Without the swap, they’d experience a negative return.
Positive’s better than negative.
How is it that If the index goes down the equity payer gets 2.5% gain?
They don’t get a 2.5% gain.
They lose 1.25% on their equity portfolio, and receive 2.5% on the swap; their gain is 1.25%.
The point of the swap is that the equity payer gains 1.25% _ net _ every quarter, irrespective of the return on the equity portfolio.
Now I understand, Thanks everyone
Oh thats right. They get 2.5% on the swap but they lost money on the equity position. Could they hold the equity swap as a naked position? Then they would gain 2.5% since they lost nothing on the equity by not holding it.
Yes, they could.
My pleasure.