Investors can achieve or modify their equity risk exposures using equity swaps and equity forwards and futures.
Equity Swaps
An equity swap is a derivative contract in which two parties agree to exchange a series of cash flows whereby one party pays a variable series that will be determined by a single stock, a basket of stocks, or an equity index and the other party pays either:
- a variable series determined by a different equity or rate or
- a fixed series. An equity swap is used to convert the returns from an equity investment into another series of returns, which either can be derived from another equity series or can be a fixed rate.
There are three main types of equity swaps:
- receive-equity return, pay-fixed;
- receive-equity return, pay-floating; and
- receive-equity return, pay-another equity return.
Because they are an OTC derivative instrument, each counterparty in the equity swap bears credit risk exposure to the other. For this reason, equity swaps are usually collateralized in order to reduce the credit risk exposure.
A total return swap is a slightly modified equity swap; it also includes in the performance any dividends paid by the underlying stocks or index during the period until the swap maturity. The swap has a fixed tenor and may provide for one single payment at the end of the swap’s life, although more typically a series of periodic payments would be arranged instead.
Equity swaps provide synthetic exposure to physical stocks. However, equity swaps require putting up collateral, are relatively illiquid contracts, and do not confer voting rights.
Equity Swap vs. Physical Stock
| Advantages | Disadvantages |
|---|---|
| Gain exposure to equity when participation in physical market is restricted | Equity swaps typically require collateral |
| Avoid tax on physical ownership (i.e., stamp duty) | Swaps are illiquid |
| Avoid custody fees on physical ownership | Swaps do not convey voting rights |
| Avoid the cost of monitoring physical positions, which may increase due to corporate actions (i.e., dividend payments, stock splits, buy-backs, M&A, etc.) |
Equity Forwards and Futures
Equity futures are exchange traded, standardized, require margin, have low transaction costs, and are available on indexes and single stocks. They enable market participants to do the following:
- Implement tactical allocation decisions (alter the exposure to equity of a portfolio).
- Selling futures (short position) reduces equity exposure.
- Buying futures (long position) increases equity exposure.
- Achieve portfolio diversification.
- Gain exposure to international markets.
- Make directional bets on the direction of the market.
Forwards provide many of the same advantages but lack liquidity and are not subject to mark-to-market margin adjustments. Because there is no clearinghouse, the credit quality of the counterparties is a concern. The major advantage of forward contracts is they can be customized.
Index futures have a multiplier. The actual futures price is the quoted futures price (in points) × the multiplier.
Short equity futures positions can be used to decrease the beta of a portfolio, and long positions can be used to increase the beta of a portfolio.
where:
βT = target portfolio beta
βP = current portfolio beta
βF = futures beta (beta of stock index)
MVP = market value of portfolio
F = futures contract value = futures price × multiplier
Cash Equitization
Cash securitization (also known as “cash equitization” or “cash overlay”) is a strategy designed to boost returns by finding ways to “equitize” unintended cash holdings. By purchasing futures contracts, fund managers attempt to replicate the performance of the underlying market in which the cash would have been invested. Given the liquidity of the futures market, doing so would be relatively easy. An alternative solution could be to purchase calls and sell puts on the underlying asset with the same exercise price and expiry date.
where:
βP = current portfolio beta of cash position = 0 (note cash has a beta of 0)
MVP = cash position