Forward Conversion with Options Diagram and Total Return Equity Swap

CFA Level III
#1

  1. for the Total Return Equity Swap, if the investor enters into swap to pay total return on stock and receive LIBOR, no matter if the stock is higher or lower than Labor, investor will receive LIBOR amount, right?

  2. for the Forward Conversion with Options, will the payoff diagram still like a collar? Both call and put have the same strike price, so I just want to confirm on this.

Thank you!

#2
  1. Yes, the investor will receive LIBOR, however if the total return on the stock/index is negative, the LIBOR receiver will also have a cash outflow for that negative total return which he’d pay to the swap counterparty. 2. Same strike and same maturity date on both options, therefore it’s a riskless position. It is often used to “secure” the value of a concentrated position so it can be borrowed against and increase the Loan-to-value which a lender is willing to provide.
#3

Thanks, Onward!

Makes sense now with the second one! It is just using the two options to reduce the risk of the position. So the diagram is just a horizontal line, right?

However, for the first one, if the stock is negative, that means they will receive that negative amount, right? If so, why does the LIBOR receiver needs to pay? will that be offset by the stock decrease?

Thank you!

#4

Hey dududu, glad the second point made sense to you. I totally made a mistake on the first haha, I’m so sorry, my brain must’ve been friend, lol. You are correct the LIBOR reciever will always receive LIBOR, but on top of that might receive yet another cash flow if the return on the equity index was negative

#5

We all have been there :slight_smile:

If the return on the equity index was negative, they need to “pay” negative amount which means receiving that amount. However, their original equity position return is negative as well right? Receiving a negative amount + paying a negative amount = 0. If this is correct, why would they receive an additional cash flow?

Thanks for your help!

#6

Haha ok I think you’re getting a bit confused here, lets take it a step back. Lets say party A wants to receive LIBOR and pay the return on S&P500 Lets say party B wants to pay LIBOR and receive the return on the S&P500 If the S&P500’s return is +10% Party A will receive LIBOR and pay 10% Party B will pay LIBOR and receive 10% If the S&P500’s return is -10% Party A will receieve LIBOR and pay NOTHING Party B will pay LIBOR (and lose 10% on the S&P500 - i.e. pay to party A the cash flow equivalent of -10%)

#7

If it’s still not clear, maybe someone else can chime in? :slight_smile:

#8

Hi Onward,

Thanks a lot for your help! I think I am clear now! For some reason, I was still thinking about the different derivatives with the underlying position.

Your examples showed what Kaplan states:

If the return exceeds LIBOR, the investor pays the difference (10%-LIBOR).

If the return is less than LIBOR, the investor receives the difference (LIBOR - 10%)

Thank you!

#9

Sweet :slight_smile: glad it all came together, best of luck dududu :slight_smile:

#10

You have been helping me a lot! Really appreciate that!!

Good luck to you as well :slight_smile: