Going through the pricing of Equity swaps, pay fixed and receive equity return.
A bit unclear why are we finding the fixed swp rate based on the floating LIBOR rates? In Equity swap we price it based on the assumption that we issue a fixed rate bond and invest the proceeds in an equivalent equity portfolio, not a floating rate bond. Are we assuming that the equity portfolio is going to return (on average) the LIBOR rate?
Why not use implied volatility of the equity portfolio to price it? It’s a hard to believe that the swap would have same price in all volatility conditions (assuming LIBOR doesn’t change with high volatility, like in market distress).
I would think that the fixed/floating leg would pay LIBOR plus a spread, to account for the fact that the equity return is not risk-free. Nevertheless, the technique for calculating the fixed rate is the same as for all other swaps; that’s the point.
Wonderful article S2000, as someone who hasn’t covered this bit yet, are there any benefits to using an equity swap (opposed to just the equity) aside from the leverage you can gain? Seems the payoff would be identical less the spread, so in effect is that cost just the financing cost for the levered up exposure?
When you enter a swap, you want to hedge risk. You need to pay floating rates? You need to pay equity returns? Then better pay a fixed rate. How do you calculate it? A fixed rate that makes the value of the swap equal to zero at the swap contract initiation.
A swap can be seen as a group of FRAs, however off-the-market ones because the swap uses an “average” rate of LIBOR rates. Remember we use LIBOR to value FRAs or simply Forwards, so since a swap is a chain of forwards, an average rate that equals all their values to zero is needed.
In equity swap we are not really hedging our exposure to interest rates, we want to hedge our equity exposure. Or probably even speculate.
Think from equity swap market maker’s point of view. How are they going to hedge their risk? They will be paying you the equity returns in case market goes down. So they will not be really concerned with what’s going to happen with floating rates but about market volatility.
Usually in equity options world, the volatility surface is skewed, with out of money puts priced higher than out of money calls. The is because markets can fall very quickly. So how is the market maker going to hedge, buy the expensive puts, in times of distress they can shoot up?
So, as s200magician suggested, they might add a spread to the fixed rate. Or probably might even refuse to make a market.
Would be great if someone working with equity swaps can share their experience.