Total return equity swap

CFA Level III Portfolio Management
#1

Guys,

I have a question on one of the hedging strategies on concentrated assets. In their example, the investor holds equity shares of a stock.

Total return equity swap: The investor enters a swap to pay the total return on the stock and receives LIBOR. They say the investor is fully hedged. If the return on the stock exceeds LIBOR, the investor pays the diference which eliminates any gains on the stock. If the return on the stock is less than LIBOR, the investor receives the diference, so his return is LIBOR.

I’m very confused.

  1. If return on stock > LIBOR: wouldn’t the investor still gain from the appreciation on the stock since he holds the stock? He would just be losing the difference from the stock performance to LIBOR, right?

  2. if return on stock < LIBOR: wouldnt the return be just the difference from LIBOR to the stock performance? “The investor receives the difference”.

  3. Whats the rationale behind this total return equity swap for the counterparty? I mean, if stock return is negative, he wouldn’t get anything and pay LIBOR. Also, if stock return is less than LIBOR, he would be losing as well.

Thanks guys

#2

  1. His net value will remain the same. Yes the stock will appreciate, but because he is short the stock, he will have to give the profits to the other side of the swap minus libor. He will net libor.

  2. If his stock went down, then the other side will give him the loss plus libor. difference, so his net increase is libor.

  3. For the side recieving the stock profit, the rationale is that they feel the stock will outperform libor and they do not have to sell their libor bonds. For the side receiving the libor, their rational is they wish to be more uniform in value to either remove the risk of the stock for a higher loan value or because they wish to be more conservative.

#3

Thanks gad4. Very clear and helpful.

Just one consideration. Aren’t the payoffs for the side receiving the stock profit much worse? I mean, its only a gain for him if the stock actually outperforms LIBOR. If the stock return is negative, or even if its positive but below LIBOR, its a loss.

#4

Its the same as writing option derivatives. The option premium received in selling a call option is limited (limited payoff to the writer), but the potential loss of writing the options is unlimited (unlimited payoff to the buyer). This analysis includes only the PAYOFF and not the PROBABILITY of the payoff.

Same principle here: The PAYOFF here for the counterparty may be low, but the PROBABILITY of payoff may be high, explaining the motivation for the counterparty to agree to the swap transaction.