March 16, 2010

How Do Equity Swaps Work?

You’re at your desk doing a last copy edit on the shareholder letter for the annual report. You glance at your daily trading, as IR folks do. You frown. You drink tepid Starbucks from yesterday and wince. For the third straight day your stock is marching up on light volume.

Your first thought is that it beats the alternative. Next is how it would be nice to know what the heck’s behind it.

One answer is equity swaps. Options expirations stretch across the balance of this week again, with volatility expiries tomorrow and stock and index (and currency, treasury, interest-rate instruments too) options and futures expirations Thursday and Friday. We think traders sometimes miss the importance of expirations by looking at the wrong data. It’s not in puts or calls so much as program equity trades, we believe. Data lead us to conclude that adjustments to derivative instruments in which investors offload various consequences and obligations associated with actually owning stuff has a big bearing. These are swap instruments.

Equity swaps could take any form but here’s an example. Say you’re running a total return portfolio that seeks to outperform the S&P 500. You could try to achieve it by picking stocks, but since 90% of managers don’t beat the market, the odds are against you. You could use managed futures, a popular way to follow a trend and add yield. But you’ve got futures trading issues, then.

So instead you call Deutsche Bank and arrange an equity swap. You agree to pay the bank a fee of some number of basis points over LIBOR (London Interbank Offered Rate) to receive the return on the S&P 500 Index via set monthly payments. That means capital gains and income distributions too. If the return is negative, Deutsche Bank is paying you, and if not, you’ve got a low-cost hassle-free way to produce your returns. Then with the money you’re saving on trading commissions, you do some short-term leveraged options to get a little yield. Presto, bingo, you’re delivering the goods (you hope).

But Deutsche Bank may adjust its assets and positions. If it’s got exposure, maybe it trades inversely correlated securities to reduce costs and limit risk. Especially around expirations. These rebalances can have a bigger impact on stock prices than puts, calls or portfolio events. Add in sophisticated proprietary trading systems that try to find these hidden rebalances and capitalize on divergences and you have a recipe for head-scratching performance.

Or in other words, the answer to why your stock goes up on light volume. It may be that a counterparty must pick up shares to change its exposure profile, and your stock, as you wrap up another annual-report cycle, is the unexpected winner on light but purposeful algorithmic buying.

Deutsche Bank is an illustration only. But these sorts of things are common. Risk-management activity can impact your price regardless of what business you’re in or what you’re communicating to shareholders in that letter.

And admit it, knowing is rather cool.

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