Valuation Series [Part 1]: Equity Total Return Swaps

A friend of mine in office, expressed privately, that he does not know a lot about Equity Total Return Swaps.

We work for a large American Bank. We normally know such things - not because we are some genius. Its primarily because we have studied such things or implemented its trading/valuation in a bank sometimes functionally or technically.

Financial concepts aren't complex; but they often seem that way by design, almost as if, there’s a deliberate effort to keep them obscure for the general public.

Look at the name of this financial product - "Equity Total Return Swaps"

It's not implicit at all. Best guess would be, its something to do with "equity" that we have to return "totally" and hence swap it :)

This article is an attempt to break it down in a language that we understand. A language that's not used in text books. My language !

Analogy helps.

Let’s imagine you’re eyeing a sleek sports car - Porsche. You want all the thrills of driving it without the commitment of buying. Been there?

Still there? Let's move on. I will use a different analogy going forward ;)

Some people in the magical yet boring world of finance, want to do the same with Stocks of companies (like Apple, Microsoft etc.) or Indices of Stocks (like SnP500, Nifty50 etc). They want the returns associated with the stock/indices/basket (by return I mean dividends, upside performance potential, profits etc.) without buying it.

Its similar to living in a beautiful holiday home airbnb for few days, and enjoying the amenities, swimming pool, breakfast etc. without having the need to buy it.

It’s not free, but you’re not paying the full price either.

What's Equity TRS?

So, what exactly is an Equity TRS? In simple terms, it’s an agreement where one party pays the total return on an equity asset (like the Airbnb owner letting you enjoy their property) while the other pays a financing rate (you covering the cost for a few days).

Its a derivative contract that has two legs: (1) Total Return Leg (2) Financing Leg

The Maths - Valuation i.e. PV of Equity TRS

Lets consider a popular stock from Indian stock market i.e., the heavy weight Reliance Industries Limited (RIL) and consider hypothetical dividend values and capital gains. The financing rate is assumed to be 5% and discount rate is assumed to be 4%.

In actual implementation the discount rate is never static and nor is the financing rate. But my focus is to sell the logic, not the math :)

Now lets put the summary of the calculation in below table for four year period.

The PV is calculated using usual formula

PV of Cash Flow = Cash Flow / (1 + Discount Rate)^t

Net Present Value (NPV) of the TRS will be the difference between Return leg and Financing Leg.

PV?of?TRS = PV?of?Total?Return?Leg ? PV?of?Financing?Leg

Here, the difference is ?2,658

This implies, that the Equity TRS has a small positive present value for the total return receiver, indicating a slight advantage for them over the financing leg payer in this scenario.

Actual implementation of this at a bank is a bit more complex. But the logic is the same.

I plan to share the math and logic of PV calculation on various kinds of financial instruments in days to come. I will also prepare an excel spreadsheet that illustrates the calculation at each step in future.

#Valuation #FinancialInstruments #TRS #Equity #InvestmentBanking