Diversifying Equity Risk
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Equity swaps offer a valuable solution for clients who wish to capitalize on the appreciation of their stocks but are not yet ready to sell. This situation may arise due to concerns about increasing tax costs from selling. Instead of selling the stock, clients can enter into an equity swap to exchange the total return of their stock position for a different fixed, floating, or index return. This allows them to benefit from their stock's value without immediate selling.
Example:
A client holds a long-standing position in Sears & Roebuck Corporation inherited from their family. The holding has appreciated to $350 per share over time. While the client wishes to diversify their portfolio, they are reluctant to sell the shares. To achieve this, the client can consider an equity swap where they pay the total return (including dividends and capital gains) in exchange for a fixed rate, such as 4.5% annually. For instance, if the stock provides $6.00 in dividends and $6.00 in capital appreciation during the first six months:
$6.00 + $6.00 / $350 = 3.43% return.
The 4.5% annual rate would equal a 2.25% return over six months, bringing the amount to:
The calculation for the payment to the client's counterparty is as follows: \((3.43\% – 2.25\%) \times \$350 = \$4.13 \) per share. With a holding of 100,000 shares, the total payment would amount to $413,000. It's important to note that if the shares had underperformed the fixed annual rate, the payment direction would have been reversed, with the counterparty paying the client instead.
Cash equitization refers to a process in which investors have significant cash positions and wish to increase the yield on these assets. The term “equitizing” refers to converting cash into equity. In this approach, investors purchase derivatives to increase the beta of their holdings, thus aiming to benefit from potential market gains. Forwards, futures, and options are utilized as they offer leverage, allowing investors to acquire the desired equity exposure with only a portion of the total value. This concept is similar to pre-investing, or getting a head start in the markets when an investor knows they will soon receive wealth.
Example:
An investor expects to receive $11,000,000 from a recent lawsuit at the end of the year. They have discussed this with their financial advisor. Instead of immediately using the entire $11,000,000, the investor and the client prefer to keep the principal invested in cash notes. However, they want to replicate a $11,000,000 portfolio using futures contracts. The selected near-term index contracts have a price of $8,200, and each contract is valued at $10 per index point, making the total contract worth $82,000.
The formula for calculating exposure:
$$ N_f = \left( \frac {B_T}{B_f}\right) \times \left(\frac {S}{F} \right) $$
Where:
\(N_f\) = The number of futures contracts.
\(B_T\) = Target beta of the portfolio.
\(B_f\) = Beta of a futures contract.
\(S\) = Size of the portfolio ($’ s).
\(F\) = Price of a futures contract.
\(N_f = \left(\frac {1.0}{1.0} \right) \times \left(\frac {\$11,000,000}{\$82,000} \right) = 134.14.\) The advisor should purchase 134 contracts on the index to replicate a $11,000,000 investment in the underlying.
Question
An investor is approaching retirement and has accumulated a significant position in his company's stock (Ticker: KPO), which trades on the ESP 500 Exchange. Anticipating a lower tax bracket in the coming years, he wants to hedge his position without selling the stock. The least likely strategy for this investor involves:
- Selling futures on KPO Stock.
- Buying futures on KPO.
- A pay KPO; Receive ESP 500 swap.
Solution
The correct answer is B.
In this scenario, the investor wants to hedge his position in the stock to mitigate potential losses. The most suitable strategy for achieving this hedge is to buy futures on the stock. By buying futures, the investor can protect himself against a decline in the stock's value. This is because gains in the long futures position will offset stock price losses. Therefore, option B is the least appropriate strategy, while options A and C could be effective in this situation.
Reading 18: Swaps, Forwards and Futures Strategies
Los 18 (e) Demonstrate the use of derivatives to achieve targeted equity and interest rate risk exposures