Hedging an Equity Position

We have mentioned in Section 6.4.2 that a possible investment is to purchase equity in the form of shares. Equity return swaps (or simply equity swap) can be used to hedge this type of investment and to transform the return in a spread over a floating rate.

In Table 7.8 we show the example in which the institution has invested in S, a certain amount of shares. The return on this investment is measured at each time t, and defined as the share value at that time minus the share value at the previous time, that is, Si – Si-1. This return is passed on to the swap counterpart, which in turn pays a floating rate plus a spread s. Note that, as we have mentioned in the previous section referring to the bond price, the return in the share price Si – Si-1 can be positive or negative. Thus the pay leg of the swap (from the bond holder's point of view) can result in a payment (if Si > Si-1) or in receiving a payment instead from the swap counterpart

TABLE 7.9 Taking a view on interest rates by locking a fixed rate.

(if Si < Si-1). As mentioned before, the payment in the latter is in addition to what the swap counterpart is already paying in the form of floating rate plus s.

Locking an Interest Rate Position

All the strategies shown in the previous sections, the conversion of a fixed or structured coupon bond, the conversion of a fixed-rate loan, the conversion of a foreign currency bond, or the conversion of an investment in equity or credit-linked securities, means that we are net receivers^[1] of floating cash flows in a set of currencies.

Let us imagine that the institution decides to take a view on interest rates in currency X where it believes that either these are about to decrease throughout the entire rate's term structure or that the swap curve is inverted, that is, the very long-term rates are lower than the short-term ones.

Let us imagine, as shown in Table 7.9, that we are in the unlikely but not completely inconceivable position in which all our net receivables can be bundled in a set of floating cash flows indexed to a floating rate Lj plus a spread s. We would enter into a swap where we pay exactly the same cash flows and receive a fixed coupon C. The value of the coupon would be such that the two transactions are financially equivalent at the time where we enter into this structure: should the interest rates decrease as expected we will be making a profit. Note that in the above table we have omitted the final cash flow: as opposed to the representation of the other structures in the previous sections, the first line is rather fictitious in the sense that it should bundle all our (hypothetically never ending) net receivables. Since it is not an actual transaction, there is no real value in adding a final principal repayment.

• [1] Our net, hopefully positive, position is the result of summing our lending, borrowing, and investing activities.