Managing Portfolio Risk with an Equity Swap - Essential Guide for the Asian Fund Manager
Team Latte
Apr 28, 2003

A lot of Asian equity fund managers are bearish on stocks in the short term but think that in a year or 18 month's time stocks would continue their northward march once again. They want to rough it out for the next 12 to 18 months and then they would want to be long equities once again. In the mean time they are unwilling to disturb their portfolio of stocks.

What is a good way to play the stock market for such a fund manager who is bearish in the short term about the prospects of equity investing, however, he feels certain of the longer term gains to be had from being invested in stocks? He wants to hold on to his portfolio - perhaps, of blue chip stocks - which is declining in value but doesn't want to lose any more money nor does he want to get into expensive equity index options and pay additional cash for this kind of protection.

Say, there is an equity fund manager who is holding Hong Kong stocks and for simplicity let us assume that his portfolio closely mimics the Hang Seng index. He feels that in the next 12 months, at least, the markets will trend down and there is downside to his portfolio but after that the index, and his stocks, will reverse and head up. His stocks pay dividend which he wants to continue to enjoy, and he does not want to disturb his portfolio - for whatever reasons - and yet he wants to limit his downside without incurring any cash outlay; and while doing so he wants to continue to get fixed bond like returns. Is such a thing possible? Such a thing is definitely possible using what is called an "equity swap".

Let us take an example. Say, a fund manager's portfolio is valued at HK$50 million and more or less tracks the Hang Seng index and the index currently stands at 9,500. He agrees to enter into an equity swap with a bank, say Bank HK, for one year in which he agrees to pay, per quarter, the return on Hang Seng index times $5,265 per index point times the index value in return for receiving a fixed rate payment from the bank equal to 2% times a notional principal amount (swap amount) per quarter. The swap is shown schematically below:

The pay-floating/receive-fixed swap cash flows per quarter for the fund manager is:

Note that the swap does not disturb the fund manager's portfolio and he continues to get the dividend equal to, say, HK$1,250,000 per quarter. Also, there is no cash cost for entering the swap nor is there any capital outlay any time during the life of the swap. What is involved is periodic exchange of cash flow between the fund manager and Bank HK.

The swap notional amount should be equal to the value of the portfolio (or very close to it) and with the current index standing at 9,500 the per index point value that equalizes the two is HK$5,265. The swap notional value is therefore HK$50,017,500. This is very close to the fund manager's portfolio. Hence the pay side of the swap for the fund manager has the term $5,265.

The fund manager receives a fixed amount equal to HK$1,000,350 per quarter from Bank HK. This amount is simply 2% of the swap notional amount. But the fund manager pays a floating amount equal to the index return (as measured by, say, the closing prices) per quarter time HK$5,265 times the notional principal of the swap. This floating side payment could be anything depending on where the index goes every quarter and holds the key to the entire strategy. Two scenarios are chosen. Let us say assume a scenario when the fund manager is proven right. The stock market indeed goes down and the Hang Seng index drops (as he had expected). The cash flows are shown below in Table 1.0.

Column 2 shows the fixed interest received by the fund manager per quarter, i.e. 2% times the notional amount of the swap. Column 3 is the value of index beginning from the present level of 9,500 and closing at the end of 4th quarter. This value is unknown and I have chosen arbitrary values. However, in a more detailed and mathematically accurate analysis one would either use Monte Carlo simulation to generate the future path of Hang Seng index or use forward rates (a technique that banks, including our fictitious bank, Bank HK, would use to calculate the exact fixed swap rate). But the trend is down wards, as the fund manager had predicted and therefore the swap serves its purpose. Column 4 is the return on the index calculated as the natural logarithm of the index value change between successive periods. Column 5 is the equity side cash flow, that is the per quarter cash that the fund manager will have to pay to Bank HK. A negative value, as shown in the table, actually means cash received from the Bank. Note that the equity side cash flow, i.e. the fund manager's pay-out, is a floating rate depending on the value of the index and the index return. If the return is negative then the cash pay-out becomes negative, which means that he actually receives cash from the bank. Column 6 is the net cash flow for the fund manager arrived at by taking the difference between column 2 and column 5. In this case the fund manager's net cash flow is positive.

Table 1.1: The index goes down as the fund manager had predicted.

Analyzing the above cash flows from the equity swap we see that the fund manager is better off with the swap in a declining market. Without the swap his absolute return is negative 11.00%. This is calculated as:

Portfolio Statistics without the swap

However, with the swap we see that the absolute return is substantially improved, as can be seen from the above cash flow table. With the swap the value of the portfolio is enhanced by the fund manager's net cash flow from the swap. With the swap the absolute return becomes 9.40%.

Portfolio Statistics with the Swap

Now, things could have gone the other way as well. Let us consider the opposite scenario to the above one. What if the fund manager gets it wrong and the Hang Seng index goes up - and that too quite a bit - in the next four quarters. What happens to the fund manager's return? The cash flows are depicted in Table 1.2:

Table 1.2: The index goes down as the fund manager had predicted.

In this case the Hang Seng index goes up in the next 12 months as can be seen from column 3 of Table 1.2 above and the fund manager would have been much better off without the swap. However, with the swap the absolute return is still positive for the fund manager, i.e. 0.70%. Now it is quite likely that the Hang Seng index can really power ahead in the next 12 months and perhaps, cross the 14,000 mark. In that event the fund manager who has entered the swap due to his bearish view would indeed experience negative absolute return and substantial opportunity loss. However, the probability of that scenario happening is low and the fund manager is better off overall with the swap.

The more the index declines, that is the fund manager's view is proven correct, the more the swap would prove beneficial to the fund manager. His returns would substantially improve while keeping his portfolio totally undisturbed.

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