Equity swaps as an alternative to trading in equities

In recent years equity swaps have emerged as one of a series of equity derivative products that are playing an increasingly integral part in how hedge funds gain exposure to global markets.

The increased popularity of equity swaps is underpinned by many advantages - either when they are used in isolation, or in combination with the other, more traditional products and services offered by a prime broker.

Equity swaps (and other equity derivatives) provide synthetic exposure to physical equities. In an equity swap, the return on the underlying share is exchanged for a return based on a reference interest rate or yield.

Equity swaps are conventionally documented under the International Swaps & Derivatives Association (ISDA) Master Agreement and schedules to that agreement. Under an equity swap, the `Equity Amount Payer' (as defined under ISDA documentation) will pay the economic return on the underlying security. This return is based on a reference price. The return is paid at a specified reset date or dates.

The Floating or Fixed Rate Payer (the other party to the equity swap) pays an amount based on a reference interest rate or a fixed rate. This amount accrues over the term of the swap.

Deutsche Bank's equity swap clients include institutions and wholesale funds, banks, hedge funds, corporations and high net worth individuals. Equity swaps are favoured by counterparties such as hedge funds, as the product enables them to achieve the economic benefits of ownership of shares without the cost and expense of the consequences of ownership, such as high custodian fees in each jurisdiction to hold shares in the relevant clearing system, having to maintain records, monitor corporate actions and undertaking regular reconciliations.

To manage these consequences, traditional institutional shareholders have to employ operations staff and run a back office. Swap counterparties avoid these consequences and achieve cost savings through doing so.

In addition, there may be some tax benefits for certain holders of equity swaps in holding a synthetic exposure to shares rather than a direct exposure.

Because the swap contract is an ISDA-documented OTC derivative contract (involving no outright position in the underlying equity), one immediate benefit is that it does not tie up the balance sheet as it would with an outright equity position. Hence, equity swaps can be used as a simple and cost-effective way to achieve leverage. Some hedge funds can and do use equity swaps for precisely that purpose.

But an equally compelling reason, particularly for those funds that do not employ leverage, is for the savings equity swaps can offer on transaction costs. This is especially valuable for funds that run a strategy involving a very high volume of transactions, such as statistical arbitrage or short-term long/short equity trading, where the need to keep transaction costs under control is critical to
performance.

The ability to take advantage of the swap provider's financial 'muscle' is vital in minimising the drag on performance created by these costs.

As equity swaps have become ever more popular with these funds, the market has become more sophisticated in finding ways to keep transaction costs down. Among the refinements that have been introduced by prime services providers such as Deutsche Bank, are innovative, contractual processes to reduce the OTC market documentation required, and systems for cash flows to be combined into scheduled payments for operational ease.

Sometimes, trading through equity swaps is referred to as `synthetic prime brokerage' - with the swap contract deployed as a substitute for borrowing stock to achieve a short position, or equity finance to achieve leverage on the long side.

Many hedge funds use this synthetic prime brokerage service as part of a full service prime brokerage agreement - with equity swaps used side by side with stock loan and other services for particular parts of their portfolios.

Because equity swaps are an over the counter derivative instrument, having the proper documentation in place and being comfortable with your counterparty is hugely important.

As with any OTC derivative, credit rating is a key factor in your choice of counterparty - which gives a significant advantage to prime brokers such as Deutsche Bank, which has a AA-/AA3/AA- credit rating. When Deutsche Bank executes equity swaps, we may require our counterparty to lodge collateral. The amount of collateral depends on both the counterparty and the swap underlying or underlyings.

Each party to an equity swap bears a credit exposure to the other. If the underlying share rises in price, the equity payer is required to make a payment referenced to the increase, and conversely if the underlying share falls, the equity payer is entitled to receive a payment. Thus, when the stock price falls, there is credit risk to the equity payer, and when it rises, the other way. This is mitigated by
collateralisation being adjusted in line with price movements in the underlying shares.

Increasingly though, within a fully integrated investment bank such as Deutsche Bank, there is a requirement to provide more efficient methods of monitoring collateral requirements across the whole range of OTC and other financing products on offer.

While this has been relatively straightforward across ISDA-based products, the integration of non-ISDA products such as prime brokerage adds a new dimension. Deutsche Bank's solution to this is an innovative new product, db Xmargin, which monitors collateral requirements across a whole range of Deutsche Bank traded derivative products in equities and increasingly fixed income.

Other refinements in the past year or so have continued to ease the operational burdens for hedge fund managers. One, for instance, is customised web-based reporting of portfolios with mark-to-market pricing. Another is the flexibility for trading terms to be standardized by strategy or customised by trade.

These days, dealing in equity swaps can be conducted with seamless connectivity to program trading and electronic execution systems - a key service for funds that generate regular, large-scale automated orders. Deutsche Bank has positioned its equity swap product so that it is fully embedded into the trading infrastructure of the firm, to make execution as seamless as possible. We could only achieve this by continuing to reinforce our ethos, 'from sales to settlement', in the quest for efficiency.

Equity swaps may hence be used in isolation as a substitute for trading in equities, but also in connection with a wide range of other services depending on the requirements of the fund. Their advantages are manifold and their appeal lies in their flexibility.

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