# Help explaining Deriv. question

Add these two together… and their explanation is:

The negative equity payment increases the amount due from S LLC???

Think of a plain vanilla interest rate swap: I pay 5% fixed to the counterparty, they pay me LIBOR. If the LIBOR rate is 3%, then I pay them 5% – 3% = 2%; if LIBOR is 6%, I pay them 5% – 6% = -1% (i.e., they pay me 1%).

Now think of the equity swap: I pay them 7%, they pay me the return on the index. If the index return is 4%, then I pay them 7% – 4% = 3%. If the index return is 8%, I pay them 7% – 8% = -1%; i.e., they pay me 1%. If the index return is -3%, I pay them 7% – (-3%) = 10%.

You’re not adding the numbers; you’re subtracting a negative number.

Thank you! are they paying you overtime this week ?

Magician, can you tell me if this logic is correct?..

S is essentially going to pay a fixed rate of return at 7% per year, or ~1.75% over the period. They are willing to risk the downside if retruns are lower for the opportunity of the higher upside payment if the equity portfolio performs well.

P wants the security of know how much their returns will not be below 1.75%, and in order to get this guarantee, is will to pay above 1.75% if the period rate is above that.

Since the return is negative over the period (-3.86%), S “lost” and is responsible for making P whole with some money. Therefore, the negative equity payment increases the amount due from S.

In your explanation you said that you would pay them 7% - (-3%) = 10% but would you need to adjust the 7% for the period (91/365)?

Double time.

(Alas, two times zero is . . . .)

Looks good to me.

Yes, if the 7% is an annual number and the payments are quarterly, the payment would be 1.7452% (= 7% × 91/365). I wasn’t trying to explain the specific payments in this problem; I was just trying to give a general illustration of how equity swaps work.

By the way, all of this is easy to see if you draw a swap diagram.