Having discussed interest rate swaps and their cross-currency extension to
currency swaps as exchanges of cash flows predicated on pre-set indices, it is
natural for us to think of structuring swaps involving non-interest indices.
Equity swaps are exchanges of cash flows in which at least one of the indices
is an equity index. An equity index is a measure of the performance of an
individual stock or a basket of stocks. Common equity indices with which the
general investor is probably familiar include the Standard & Poor's 500
Index, the Dow Jones Industrial Average or the Toronto Stock Exchange Index.
The outstanding performance of equity markets in the 1980s and the 1990s,
technological innovations that have made widespread participation in the equity
market more feasible and more marketable and the demographic imperative of
baby-boomer saving has generated significant interest in equity derivatives. In
addition to the listed equity options on individual stocks and individual
indices, a burgeoning over-the-counter (OTC) market has evolved in the
distribution and utilization of equity swaps.
There are many reasons to use equity swaps, some of which come from the
motivation behind index trading.
This passive investing strategy is gaining ground in the fund management
community. Instead of trying to buy individual stocks that are deemed to be
undervalued by some method of fundamental analysis, the index trading mechanism
chooses a basket of stocks that is selected for its ability to represent the
general market or one particular sector of the stock market. The fees
associated with funds that engage in index trading are much lower because the
investment management is mechanically deterministic. It is prescribed by the
index that the investors have chosen. The investment manager is not paid for
his discretionary expertise.
Equity swaps make the index trading strategy even easier.
Consider the Bulldog S&P 500 Mutual Fund that is a fund promising to
deliver the return of the S&P 500 (less administrative and managerial
costs). How do they do it?
One way would be to buy the 500 stocks that comprise the index in their
exact proportions. However, the execution of this would be cumbersome,
particularly if the level of funds in the Bulldog S&P 500 Mutual Fund were
to fluctuate as people put more money to work or as they withdraw from the
fund.
Another way would be to participate in the S&P 500 through the futures
market by using the mutual fund's money to purchase S&P 500 Futures. The
Futures contract would have to be rolled on a quarterly basis. There would be
complex administration with the Futures Exchange.
There is a third alternative: the equity swap. The investment manager at
Bulldog calls up First Derivatives bank and asks for an S&P 500 swap in
which the fund pays First Derivatives some money market return in exchange for
receiving the return on the S&P 500 index for a period of five years with
monthly payments. The return on the S&P 500 index consists of capital gains
as well as income distributions.
The structure is easy for the passive investment manager to implement
administratively. And it fully accomplishes the goal with very little costs.
Index trading funds typically have much lower costs associated with them.
There are also tax advantages or ownership advantages associated with equity
swaps.
Let's say that you own $100 million of stock in Acme Tool & Die. The
stock has gone up 50% in the past year and you want to take profit but you do
not want to forfeit the shares. You just want someone to give you some money
today for the capital gains and income distributions of that Acme Stock for the
next five years. So you enter into an equity swap.
This is how one version of the equity swap would work.
You call up First Derivatives bank and
tell them you want to enter into an equity swap in which you would pay the
total return on Acme Tool & Die stock at one year intervals for the next
five years in exchange for which you would receive from First Derivatives bank
the payment of some money market index less a spread on the notional amount of
the equities involved.
Let's say that you enter the equity swap for $100 million of Acme stock and
that the money market index is the London Interbank Offered Rate (LIBOR). The
spread adjustment in this case is assumed to be 25 basis points (or 0.25%).
Every year you receive from First Derivatives bank the floating rate
payment of $100 million multiplied by (LIBOR-0.25%) and you pay First
Derivatives bank the total return on the Acme stock.
The total return is calculated to be the sum of the dividend pay-outs on the
$100 million of Acme stock and the capital gains or losses on the stock. Note
that if the total return is negative, First Derivatives Bank will be making a
payment to you, in addition to the payment of (LIBOR - 0.25%). The total return
that you earn on your underlying stock exactly offsets the total return
compensation you make to or receive from First Derivatives Bank.
You have not booked any capital gains on your Acme Stock. The equity swap on
an individual stock like this is not a taxable event. Plus, you have retained
the ownership rights to the Acme stock you own. You get to vote on the new Acme
business plan at the annual shareholders' meeting. Nobody at Acme will know
that you are not participating in the ups and downs of the stock.
Equity swaps also make it easier for the emerging markets fund manager.
Emerging markets (and foreign markets, generally) are often illiquid, making
it prohibitively dangerous and expensive to use a value-driven stock-picking
strategy. This is not to say that investing in emerging markets is to be
avoided, though. Under the right economic conditions, emerging markets can
deliver outstanding performance compared to developed market returns. But
liquidity and flexibility, the nimbleness with which one can get out of a bad
position, are important considerations in any investment strategy. Equity swaps
make this easier.
An emerging markets investment manager can call up First Derivatives bank
and ask for an equity swap on the South Korean stock market (one of the hottest
equity markets of early 1999).
The equity swap is more convenient for the investment manager for several
reasons.
One, the investment manager can quickly get into the South Korean equity
market and quickly (at least as quickly as is possible for the South Korean
market) get out of the South Korean equity market.
 Two, the investment fund's credit exposure
is limited to First Derivatives bank. He will get his money back once he closes
the position as long as First Derivatives is still in business. This is much
better than buying individual South Korean equities guaranteed by a South
Korean brokerage company or a South Korean clearinghouse.
Three, the investment manager can eliminate his exposure to fluctuations in
the Korean Won (the South Korean currency) by asking to have all of the cash
flows denominated in US dollars. He pays a US dollar money market rate (less a
spread) on the US dollar notional amount in exchange for receiving a US dollar
equity linked cash flow. If he had bought the individual South Korean equities,
he would own a South Korean Won asset whose US dollar value would be vulnerable
to the combination of a currency devaluation (or excessive depreciation) and a
stock market meltdown. This is precisely what happened in 1998.
Equity swaps may make it easier for investors to get around regulatory
restrictions.
A great example of this is the Canadian Registered Retirement Savings Plan
foreign content rule. Canadian investors are restricted to having no more than
20% of their Registered Retirement Savings Plan accounts (similar to the
American Investment Retirement Accounts) invested in non-Canadian assets.
The problem is that Canadian assets have under-performed US assets
consistently during the boom of the 90s, compounded by a never-ending Canadian
dollar weakness. If you had invested money in the US stock market, you would
have made better money from both the greater strength of the US stock market
and from the increased value of the US dollar compared to the Canadian dollar.
One way to get around these restrictions is to buy an RRSP-eligible US
equity mutual fund.
How do these funds maintain their RRSP eligibility while still delivering US
equity fund performance? By using equity swaps purchased from Canadian banks,
the funds are deemed to be invested in Canadian investment products. The equity
swap pays the funds the total return from the US equity market (including
currency changes, depending on the structure of the fund).
Equity swaps are powerful tools in the hand of the passive investment
manager, the investor looking to tailor the timing of his tax events,
investment managers looking for opportunities abroad and the average investor
looking to enhance his return despite the letter of government provisos.
Article by Chand Sooran, Principal Victory
Risk Management Consulting, Inc. |