Return of the Equity Swap?
Team Latte
Jun 03, 2006
In the late 1990s and very early 2000 fund managers and banks (on the sell side) discovered (or shall we say re-discovered) the product "equity swap". It also went by the name "total return equity swap".
In a bear market or in steeply falling markets a lot of investors, mutual and long-only fund managers foremost amongst them, do not want to sell off their holdings and take a loss on their equity portfolios. This could be for a variety of reasons, such as the investor may think that the bear market may not last for long or that the falling prices is just a correction and will be reversed soon head back up again. A lot of long-only (mutual) fund managers have restrictions on how much they can sell and how quickly, which also could be a restricting factor. So what should they do? Should they continue to hold their portfolio as it is and incur loss on their P & L? No, said the smart derivatives sales guy in the friendly bank but rather buy (or enter into) and equity swap, an off balance sheet transaction.
Keep your equity portfolio as it is and enter into a swap. The swap counterparty, such as the bank, will periodically (say, every six months or a quarter) pay the investor a fixed or LIBOR based (or any other benchmark) return and the investor will periodically pay to the bank a return linked to an equity index that mimics his equity portfolio. So what is the big deal? The big deal is if the equity prices are falling then the investor's return (over a period, say six months or a quarter) will be negative and hence the investors payment to the bank will be negative, i.e. the investor will receive money from the bank. Thus in the event that the equity markets go down and the investor's stock portfolio loses money (generates a negative return) he would, in addition to getting a fixed or floating rate periodic payment from the bank will also get another payment from the bank in the form of the absolute value of the return of the equity index. This will offset any of his losses.
In late 1999 and early 2000 when the equity markets crashed a lot of investors flocked to these equity swaps. Even before, the market crash, in the late nineties when the bull run was in full swing some savvy investors and fund managers were entering into equity swaps. But with the crash, the popularity of this product soared. Institutional investors who were loathe to sell their stocks in the hope that the markets will turn around in a short while embraced equity swaps like an antidote.
And then when the markets really did turn around in 2004 this product was once again forgotten. Two weeks ago, we met a hedge fund manager in Tokyo who resurrected this product to us over dinner, suggesting (only suggesting) that he may have entered into such an equity swap for he was nervous about the equity market. And then three days ago we came across a very recent presentation (see below) on the internet about equity swap by an influential banker. We thought why not bring back this product- or a mention of it -from the dead. See the links below for a detailed look at this product:
  
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