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Equity Swaps and the Exchange of Cash Flow

Equity swaps are exchanges of cash flows in which at least one of the indices is an equity index. This passive investing strategy is gaining ground in the fund management community

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 may under-performed US assets consistently, for example during the boom of the 90s, which was 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. The reverse is true in times where the value of Canadian dollar has increased compared to the US dollar such as in 2010-2013.

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.

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