FUNDAMENTALS OF SWAPS & OTHER
DERIVATIVES 2021
October 18, 2021
Live Webcast│ www.pli.edu
SWAP Basics
Equity Derivatives
Gary Rosenblum
Managing Director & Associate General Counsel
Bank of America
What are equity derivatives?
• Derivatives linked to the performance of one or more equities (shares,
indices or baskets)
• The three most common types of equity derivative transactions are:
• Swaps
• Options
• Forwards
• Unique quality of equity derivatives: Corporate Actions
• Dividends
• Stock Splits
• Mergers, Tender Offers, Insolvency and Delistings
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Equity Swaps
• An equity swap is an agreement between parties to exchange cash
flows, with one or more leg(s) based on an equity, at regular intervals
during an agreed period.
• Cash flows are calculated based on a notional principal amount
• Notional amount never exchanged
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Equity Swap Example:
• Client is seeking long exposure to Facebook shares.
• Total Return Swap: "Long party" receives stock appreciation and dividends. "Short party"
receives stock depreciation and financing "leg."
• Price Return Swap – Long party does not receive dividends.
• Both parties have counterparty credit exposure to each other.
Client
Equity appreciation
Fixed or variable rate (LIBOR/Fed Funds plus Spread)
Dealer
Dividends (if total return)
Equity Depreciation
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Client “Long” SWAP
Dealer Hedge. If client is long Swap on 100 shares of Facebook, the dealer typically hedges by
buying 100 Facebook shares. If client is short Swap on 100 shares of Facebook, the dealer
typically hedges by establishing short position in 100 Facebook shares. SWAPS are called
"Delta-1" trades because the hedge typically correlates to the national size of the trade 1 to 1.
Directionally, from the Dealer's perspective, long derivative exposure – short hedge, short
derivative exposure – long hedge.
▪ Advantages: Margin/Leverage; access to products.
Equity Options
• An agreement that gives the buyer, in exchange for the payment
of a premium, the right but not the obligation, to buy (Call) or
sell (Put), a specified number of shares or "units" at a fixed price
(strike price) for a stated time (maturity or expiration date).
• Key Terms:• Parties to the contract:
❖ Option buyer or holder (long).
❖ Option seller or writer (short).
• Strike (exercise) price: The price specified in the options contract.
• Maturity (expiration, expiry) date: The time after which the option is no longer valid.
Also called “tenor”.
• Premium: the amount the buyer pays the seller for the option.
• Warrants: long-dated call options issued by corporations.
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Equity Options
• When can an option be exercised?
• European option: can only be exercised at expiry.
• American option: can be exercised any time up to expiry.
• Bermuda: can be exercised more than once, not every day
• How can an option be exercised?
• Physically settled: Buyer has the right to buy (in the case of a call) or sell (in the case of a put) the
shares at the strike price.
• Cash settled: Buyer receives from the seller the “in-the-money” amount of the option (i.e., in the
case of a call, the final price minus the strike price and, in the case of a put, the strike price minus the
final price).
• Net Share Settled: most common with Warrants for “tacking” purposes, receives the “in-the-money”
amount in shares.
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Option Building Blocks
In/Out of the Money (Facebook, 3 month options, as of 7/23)
An option is “in-the-money” if:
• in the case of a call, the spot price (i.e., $372) is greater than the strike price (i.e., $360).
• in the case of a put, the spot price ($372) is less than the strike price (i.e., $380).
• Call “premium”:
– $28 per share ($360 strike, $372 spot (premium equals 7.8% of strike))
An option is “at-the-money” if the strike price ($370) is (approximately) equal to the spot price ($372).
• Call “premium”:
– $22.50 per share (6.1% of strike)
An option is “out-of-the-money” if:
• in the case of a call, the strike price (i.e., $380) is greater than the spot price (i.e., $372).
• in the case of a put, the strike price (i.e., $370) is less than the spot price ($372).
• Call “premium”:
– $17.25 per share (4.5% of strike)
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Option Building Blocks (cont’d)
Dealer Hedge
Options are not Delta-1 because except for deep, deep in-the-money options, hedge is not on a 1 for 1 basis. Directionally, if dealer is "long" derivative (i.e., dealer buys a Call), Hedge is to go short the "Delta" (a model-based percentage of the national number of shares.)
Call option Premiums below show directionally how the hedge is adjusted (the change in "Delta").
• Out-of-the-money: Premium $17.25 per share ($273 spot, $380 strike)
• At-the-money: Premium $22.50 per share ($372 spot, $370 strike)
• In-the-money: Premium $28 per share ($372 spot, $360 strike)
As stock price increases, to hedge a Long Call, Dealer will sell additional shares (sell high).
As stock price decreases, to hedge a Long Call, Dealer will buy additional shares (buy low).
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Call Option Payoffs
Long Call Short Call
-$10
-$5
$0
$5
$10
$15
$85 $90 $95 $100 $105 $110 $115-$10
-$5
$0
$5
$10
$15
$85 $90 $95 $100 $105 $110 $115
Stock Price at Maturity
• A purchased call is bullish, but unlike longstock, it has limited losses on the down-side, equal to the premium the buyer pays
• The buyer has unlimited gains on the up-side
• A sold call is bearish, but unlike shortingstock, it has limited gains on the down-side, equal to the premium the sellerreceives
• The seller has unlimited losses on theupside
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Put Option Payoffs
Long Put Short Put
Stock Price at Maturity
• A purchased put is bearish, but unlikeshort stock, it has limited losses on theup-side, equal to the premium the buyerpays
• The buyer has potential to gain on thedownside until the stock is zero per share
• A sold put is bullish, but unlike long stock,it has limited gains on the up-side, equalto the premium the seller receives
• The seller has potential losses on thedown-side until the stock is zero per share
-$10
-$5
$0
$5
$10
$15
$85 $90 $95 $100 $105 $110 $115
-$10
-$5
$0
$5
$10
$15
$85 $90 $95 $100 $105 $110 $115
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Dealer receives appreciation in Underlying Shares above a set level
Shareholder is protected from depreciation in Underlying Shares below a set level
Dealer Shareholder
• A shareholder buys an out-of-the-money put option and sells an out-of-the-money call option.
• The resulting position has limited downside and limited upside exposure to share price movements.
• The sale of the call obligates the shareholder to deliver shares at the call strike while the purchase of the put gives the shareholder the right to sell shares at the put strike.
Shareholder posts shares as collateral
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Equity Collar
Shareholder enters into a 1 Year collar with Dealer
Put Strike = $90.00 Call Strike = $110.00 Premium = $5.00 Premium = $5.00
Shareholder posts shares as collateral or “cover” against the short call position
Dealer borrows shares and posts cash collateral, and sells shares to market and receives cash proceeds
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2
Securities Lender
Cash collateral
Market
Share Price: $100.00
Shareholder Dealer
1 Year Put $90.00 strike
1 Year Call
$110.00 strike
Shareholder posts shares as collateral
1
2
Cash proceeds
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3
Shares
Shares
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Equity Collar Example
Forgone
Appreciation
Risk
Eliminated
Equity Collar Payoff Diagram
Shareholder protects downside risk below $90.00 and forgoes appreciation above $110.00, with no net upfront premium paid or received (zero-premium (cash-less) collar).
(20.00)
(15.00)
(10.00)
(5.00)
0.00
5.00
10.00
15.00
20.00
80 85 90 95 100 105 110 115 120
Price
P/(
L)
Shares Shares & Options
Current Share Price: $100.00
Put Strike = $90.00 Call Strike = $110.00
Premium = $5.00 Premium = $5.00
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Advantages Disadvantages
• Protects against downward movements below the put strike while retaining upside in the underlying shares up to the call strike
• Can be structured with no upfront net cash premium
• Option strike prices and expirations may be customized
• Retains ownership, dividends and voting rights
• Ability to borrow against value of protected position
• Ability to defer sale of underlying shares through cash-settlement of options
• Forgo appreciation above the call strike; and
• Collateral required against short call position.
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Equity Collar Pros and Cons
Call Spreads
Issuer buys a call option at a “low” strike price and sells a call option at a “high” strike price.
Typically executed in connection with convertible bond issuances to raise the effective conversion
premium of the convertible bonds.
Example
• Issuer enters into a Capped Call transaction related to its $1.0 billion aggregate principal
amount of 6.50% convertible senior notes due 2025.
• The options (Issuer purchases call struck at $19.22; Issuer sells a call struck at $35.00)
will have the equivalent effect of raising the stock price at which Issuer would incur
economic dilution from $19.22, the initial conversion price of the notes, to $35.00, the
Cap Price established pursuant to the Capped Call.
($3,000)
($2,000)
($1,000)
$0
$1,000
$10.00 $20.00 $30.00 $40.00 $50.00
Effective Payout Bond Capped Call
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Put/Call Combo (turns two “Non-Delta 1” instruments into a “Delta 1” instrument)
• Investor buys an “at-the-money” call option and sells an “at-the-money” put option.
• Provides investor synthetic exposure equivalent to that of a stock purchase.
• Call option may be physically settled if applicable Hart-Scott-Rodino (HSR) filings and waiting
periods have been met.
• Typically used by activist investors to get long exposure to underlying stock while deferring or
concurrently addressing HSR filings/waiting period.
Reg U Considerations: transaction viewed as extension of purpose credit and therefore requires
investor to post collateral equal to 50% of the notional amount.
Example
Activist hedge fund (HF) would like to acquire $200 million of shares of XYZ Company.
HF could purchase XYZ shares, but once $92 million (2021 HSR Adjusted Threshold) of XYZ stock
purchased, HF would be required to make an HSR filing and cease further purchases until HSR
waiting periods passed.
As an alternative, HF can enter a put/call combo with $200 million synthetic long exposure to XYZ
Company, which would not trigger any HSR filing/waiting period requirements. HF subsequently
can make required HSR filings and satisfy the applicable waiting period. Once HSR
requirements have been met, if call option is in-the-money, HF can physically settle and then own
$200 million of XYZ shares, if put is in-the-money, the Dealer will exercise and HF can elect
physical settlement.
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Valuing Options
Black-Scholes Model
• Most widely-used model to determine value and calculate premium (or price) of an
option.
• Calculates the fair value of a put or call option.
• Six variables serve as pricing model inputs, all of which have an impact on the cost of
maintaining the hedge portfolio: Stock Price, Strike Price, Time to Expiration, Interest
Rates, Dividend Yield and Volatility.
Increase In Put Premium Call Premium
Stock Price Decreases Increases
Strike Price Increases Decreases
Time to Expiration Increases Increases
Dividend Yield Increases Decreases
Interest Rate Decreases Increases
Volatility Increases Increases
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Equity Forwards
Basic Characteristics. In a forward, a “forward seller” agrees to sell a fixed or variable number of shares to a “forward buyer” at aprice on a future date.
Forward Price Calculation. Subject to a “floor” and cap” for “Variable Forwards”, the forward price is calculated as the future valueof today’s spot price, using an assumed interest rate typically based on the term swap rate for the period corresponding to the term ofthe contract.
Timing of Purchase Price Payment. The purchase price is either prepaid in full on trade date (in which case the forward price isadjusted to reflect an interest component) or paid at maturity (postpaid, in which case the forward price does not reflect an interestcomponent).
Pledge of Underlying Shares. If the forward seller is the client, the client typically secures its forward delivery obligation by pledgingto the dealer all of the shares subject to the forward contract. From the dealer’s perspective, this is a “covered” transaction (or, stateddifferently, a transaction in which the dealer has no credit exposure to the forward seller).
Physical Settlement. The forward seller delivers the securities to the forward buyer against payment of the forward price.
Cash Settlement. There is a comparison of the forward price to the reference price (Floors, Caps, if any, taken into account).
Net Share Settlement. The equivalent of the “Cash Settlement Amount” is “paid” by delivery of shares (no cash is exchanged).
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Equity Forwards (continued)
Dealer’s Hedge. In a non-variable (or fixed price) forward, the dealer will hedge simply by buying or selling shares equal to the underlying shares subject to the contract. In a variable forward, “delta” hedged like an Option.
Types of Forwards
1.Variable Forwards – have embedded option features. Common to have "collar like" economics, a floor and a cap, the only difference is between the bands (strikes) forward can be "exercised" at their spot.
2.Non-Variable Forwards – price and shares set on trade date. Common Issuer derivative. The Issuer likes the price, doesn’t want equity dilution today, so locks in the price.
3.Prepaid Forwards – paid on Trade Date, pre-payment
4.Postpaid Forwards – paid at Settlement
Difference with options, may be able to finance more and may have settlement between the floor and cap (i.e., between the “put strike” and “call strike”).
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Documentation of Equity Derivatives
• Equity derivatives are typically governed by:
• ISDA Master Agreement: This multi-product master agreement rarely contains
equity-specific provisions.
• Equity Definitions: ISDA has published Equity Definitions, which include many
market-standard technical terms. The Equity Definitions are typically incorporated by
reference into the ISDA or the Confirmation.
• Master Confirmation Agreement ("MCA")
❖ Each time a transaction is entered into between two parties, a confirmation is
exchanged, documenting the economic terms and other specific terms which will
apply to the transaction.
❖ Parties may enter into a Master Confirmation Agreement, which simplifies the
documentation process for equity transactions. It provides equity-specific terms to
apply to all equity transactions entered into between two parties, leaving only a
much-shorter “Transaction Supplement” to be exchanged on a trade-by-trade basis.
❖ Commonly-used forms of MCA have been published by ISDA, drafted for different
regions: i.e., North America, EMEA, Japan, and Asia ex-Japan.
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Documentation: Share Extraordinary Events
Events that may occur to the shares during the life of a derivative
transaction.
• Merger Event
• Tender Offer
• Nationalization
• Insolvency
• Delisting
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Documentation: Potential Adjustment Events
Events that may occur during the life of a derivative transaction
that has a diluting or concentrative effect on the theoretical value of
the shares
• Stock splits, reverse stock splits and reclassifications (not in a
merger)
• Share distributions
• Spin-offs
• Extraordinary Dividends
• Issuer buybacks
• Any other event that may have a diluting or concentrative effect
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Documentation: Index Events
Events:• Index Adjustment
• Index Modification
• Index Cancellation
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Documentation: Additional Disruption Events
Events that occur to a party’s hedge or ability to perform the derivative during the life of
the transaction:
• Change in Law: Due to a change in law, it has become illegal or will require an increased cost to perform a
party’s obligations under the transaction.
• Hedging Disruption: It is not possible for a party to hedge its equity price risk under a transaction or to realize
the proceeds of its hedge position.
• Increased Cost of Hedging: A party will have to incur an increased cost to hedge its equity price risk or
realize the proceeds of its hedge position.
• Loss of Stock Borrow: A party cannot hedge short exposure via a stock borrow transaction above a specified
rate (the Maximum Stock Loan Rate).
• Increased Cost of Stock Borrow: The cost to hedge short exposure via a stock borrow transaction is above
the cost of borrow (the Initial Stock Loan Rate) on the trade date (but below the Maximum Stock Loan Rate).
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