Equity Derivatives Explained by M. Bouzoubaa

By M. Bouzoubaa

A succinct ebook that offers readers with all they should learn about the fairness derivatives enterprise. It offers with vanilla fairness items, their utilization, structuring and their possibility administration. the writer successfully bridges the distance among idea and perform, continuously linking threat administration instruments with particular company objectives.

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The initial spot price is equal to $70 and both contracts are written on 20,000 shares. The notional N is then equal to $1,400,000. The strike price is equal to 110% of the initial spot price: $77. We assume the long position in the forward contract was taken at zero cost, as the strike price was equal to the theoretical forward price at the trade inception date. Let’s also assume that the holder of the call option had to pay a premium priced at 7% of the notional. The long forward position makes a profit if the spot price at maturity is higher than 110% of the initial spot price.

When the bank pays the return of Stock X on a notional N, it takes a riskless position by buying the same notional of Stock X for its own trading book from the market. Any equity performance paid or received by the investment bank from the equity swap transaction is offset against the realized P&L from its long position in Stock X. In fact, investment banks do not make their money by speculating on stock markets when dealing equity swaps; their positions are usually hedged, and their P&L comes from commissions, interest spreads and paying lower dividends than the actual amounts received.

7 illustrates the outcome under the equity swap depending on the settlement method applicable at maturity. Client may choose physical or cash settlement. 8 shows the hedging process behind most of equity swaps offered by investment banks. When the bank pays the return of Stock X on a notional N, it takes a riskless position by buying the same notional of Stock X for its own trading book from the market. Any equity performance paid or received by the investment bank from the equity swap transaction is offset against the realized P&L from its long position in Stock X.

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