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Equity / share swaps

Introduction

An equity / share swap is a fixed-for-equity swap. It is similar to the conventional interest rate swap in terms of a term to maturity, notional principal amount, specified payment intervals and dates, fixed rate and floating rate. The difference lies therein that the floating rate is linked to the return on a specified share index (usually total return, i.e. capital appreciation and dividend). The following are the sections covered here:

• Example of equity / share swap

• Variations on the theme.

Example of equity / share swap

These swaps are a relatively new invention (first emerged in 1989), and are used for temporary desired changes to the income of a portfolio without having to sell the relevant instrument/s. For example (see Figure 9), a portfolio manager may believe that equities are to yield inferior returns for, say, two years, and that over this period bonds should perform well. An equity / share swap is an ideal instrument for this purpose, i.e. the share return is swapped for a fixed rate of return for two years.

example of an equity swap

Figure 9: example of an equity swap

It will have been noted that the intermediary bank (who arranged the deal) profits by 0.2% pa on the fixed leg (LCC200 000 pa for 2 years). The two principals (pension funds) are not aware of this because they deal with the bank.

Variations on the theme

There are some variations to this plain vanilla equity / share swap:

• Floating-for-equity equity swap: An equity swap with one leg benchmarked against a floating rate of interest and the other leg benchmarked against an equity index.

• Asset allocation equity swap: An equity swap where the equity leg is benchmarked against the greater of two equity indices.

• Quattro equity swap: An equity swap with two equity legs, the return on one equity index is swapped for the return on another equity index.

• Blended-index equity swap: An equity swap where the floating leg is an average (weighted or otherwise) of two or more equity indices.

• Rainbow-blended-index equity swap: Same as the previous, but the indices are different foreign indices.

Commodity swaps

Commodity swaps are where parties exchange fixed for floating prices on a stipulated quantity of a commodity (for example a 20 000 ounces of platinum). An example: a South African producer of platinum wishes to fix a price on part of its production (20 000 ounces), because it is of the opinion that the price of platinum is about to fall (wants to receive fixed, i.e. a fixed price, and pay floating, i.e. the spot rate).

On the other hand, a manufacturer of jewellery in Italy believes that the price of platinum is about to rise sharply (wants to pay fixed, i.e. fixed price, and receive floating, i.e. spot price).

example of a commodity swap

Figure 10: example of a commodity swap

An on-the-ball intermediary bank spots this difference of opinion and puts together the following deal (spot price at inception of the deal is USD 1 529 per ounce):

• The bank offers the mine a fixed price of USD 1 528 per ounce for the next 2 years, payable monthly, in exchange for monthly payments of the average spot rate for the preceding month.

• The bank offers the jewellery manufacturer monthly payments of the average spot rate for the preceding month, in exchange for a fixed price of USD 1 530 per ounce for the next 2 years, payable monthly.

Both parties cannot believe their good fortune and accept the deal. The banker is also pleased. It will be apparent that if the platinum price falls, the mine will be extremely pleased, because it receives the ever-declining price on the spot market and pays this to the intermediary bank. In exchange the miner receives the fixed price of USD 1 528 per ounce.

The jewellery manufacturer, on the other hand, will be smarting because it is paying floating in the spot market and receiving this same amount, while paying a fixed price that is increasingly higher than the spot price. The opposite case will be obvious. This swap deal is depicted in Figure 10.

Listed swaps

Generally speaking the swap market is an OTC market "made" by the banks (see next section). However, in certain markets listed swaps are listed on financial exchanges. In some countries the following listed swaps are found:

• Plain vanilla swaps.

• Coupon swaps.

• On-demand swaps.

• Bond look-alike swaps.

• Overnight swaps.

Organisational structure of swap market

organisation of derivative financial markets

Figure 11: organisation of derivative financial markets

As noted, the swap market is largely an OTC market and it is dominated by the banks. As such, it is largely a primary market. As in the case of OTC forwards, the OTC swaps are difficult to sell and "getting out" of them amounts to finding an equal and opposite OTC deal (which is not always easy to find).

This also applies to the listed swap market, but there is a major difference: the contracts are standardised, and exchange-traded, and trading "out" of them is easier. Another advantage is that the exchange guarantees the swap deals.

In the OTC swap market the trading driver is "quote" (mainly done by the banks) whereas in the exchange-driven market participants place orders with their broker-dealers. The trading system in the OTC market is screen / telephone, i.e. firm prices are quoted on screen and confirmed on the telephone. In the exchange-driven markets it is a combination of ATS and screen-telephone.

Summary

Swaps are obligations to swap cash flows ion future dates. They are used to transform liability and asset portfolios and to take advantages of pricing / credit anomalies in markets. The market is usually OTC but some swap products are traded on exchanges.

Bibliography

Bodie, Z, Kane, A, Marcus, AJ, 1999. Investments. Boston: McGraw-Hill/Irwin.

Faure, AP, 2005. The financial system. Cape Town: QUOIN Institute (Pty) Limited.

McInish, TH, 2000. Capital markets: A global perspective. Massachusetts, USA: Blackwell Publishers Inc.

Mishkin, FS and Eakins, SG, 2000. Financial markets and institutions (3e). Reading, Massachusetts: Addison-Wesley.

Rose, PS, 2000. Money and capital markets (international edition). New York: McGraw-Hill Higher Education.

Saunders, A, 2001. Financial markets and institutions (international edition) New York: McGraw-Hill Higher Education.

Santomero, AM and Babbel, DF, 2001. Financial markets, instruments and institutions (2e). Boston:. McGraw-Hill/Irwin.

 
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