R13 - Conc Single-Asset Positions - Equity Monetization Tools

[RaulS]

Hello Guys,

Have a question regarding establishing short position in stock as outlined under Equity Monetizations tools.

Could somebody explain -

1. Total Return Equity Swap - How money market rate of return (i.e. Rf rate) is being earned on full value of hedged position? Since $100 MM fully hedged value (ABC Corp. example) isn’t actually invested in money market .

2. Forward conversion with Options - similar to above on how money market rate of return is being earned? If either one of long put or short call option is exercised - wouldn’t investor have to deliver (effectively selling) his/her 1 MM ABC long share holding to fulfill obligation - hence investor not owning stock anymore?

3. Equity Forward Sale contract - how money market rate is being earned?

It would be helpful to get an understanding in terms of ‘Short Sale against the Box’ explaination by Will660 as per link below:

https://www.analystforum.com/forums/cfa-forums/cfa-level-iii-forum/91361673

Thank you in advance!

[Black8Mamba23]

I’ll take a (brief) shot at this, maybe this helps. Hopefully you’re graced enough that S2000 chimes in with .

@RaulS

1. Total Return Equity Swap - How money market rate of return (i.e. Rf rate) is being earned on full value of hedged position? Since $100 MM fully hedged value (ABC Corp. example) isn’t actually invested in money market .

The swap exchanges the returns on your risky stock position for a money market rate of return. Gains/losses on the stock are paid/received to/from the counterparty, in exchange for the money market rate of return spelled out in the terms of the contract.

@RaulS

2. Forward conversion with Options - similar to above on how money market rate of return is being earned? If either one of long put or short call option is exercised - wouldn’t investor have to deliver (effectively selling) his/her 1 MM ABC long share holding to fulfill obligation - hence investor not owning stock anymore?

Think about Put-Call Parity. S + P = C + Ke^-rT. We then have that S + P - C = Ke^-rT. Now, the left hand side looks like your long position with a forward conversion with options (i.e., long put, short call, struck both at K expiring at T). By PCP, that’s equivalent to holding a position of Ke^-rT dollars in the risk-free asset, with a maturity payoff of K. So your position between t = 0 and t = T will earn risk-free rate of return.

@RaulS

3. Equity Forward Sale contract - how money market rate is being earned?

Think of the formula for pricing an equity forward contract (supposing non-dividend paying underlying). You’re agreeing to sell your stock at T at the forward price which is the stock’s price today multiplied by e^rT. Effectively you’re selling the stock today and earning the risk-free rate until the maturity payoff at time = T.

In none of the cases are you “actually” holding a money market instrument, but your position in the derivative contracts effectively makes it one. Hope that helps

[rexthedog]

@Black8Mamba23

I’ll take a (brief) shot at this, maybe this helps. Hopefully you’re graced enough that S2000 chimes in with .

@RaulS

1. Total Return Equity Swap - How money market rate of return (i.e. Rf rate) is being earned on full value of hedged position? Since $100 MM fully hedged value (ABC Corp. example) isn’t actually invested in money market .

The swap exchanges the returns on your risky stock position for a money market rate of return. Gains/losses on the stock are paid/received to/from the counterparty, in exchange for the money market rate of return spelled out in the terms of the contract.

@RaulS

2. Forward conversion with Options - similar to above on how money market rate of return is being earned? If either one of long put or short call option is exercised - wouldn’t investor have to deliver (effectively selling) his/her 1 MM ABC long share holding to fulfill obligation - hence investor not owning stock anymore?

Think about Put-Call Parity. S + P = C + Ke^-rT. We then have that S + P - C = Ke^-rT. Now, the left hand side looks like your long position with a forward conversion with options (i.e., long put, short call, struck both at K expiring at T). By PCP, that’s equivalent to holding a position of Ke^-rT dollars in the risk-free asset, with a maturity payoff of K. So your position between t = 0 and t = T will earn risk-free rate of return.

@RaulS

3. Equity Forward Sale contract - how money market rate is being earned?

Think of the formula for pricing an equity forward contract (supposing non-dividend paying underlying). You’re agreeing to sell your stock at T at the forward price which is the stock’s price today multiplied by e^rT. Effectively you’re selling the stock today and earning the risk-free rate until the maturity payoff at time = T.

In none of the cases are you “actually” holding a money market instrument, but your position in the derivative contracts effectively makes it one. Hope that helps

S2, That U?

[S2000magician]

@rexthedog

@Black8Mamba23

I’ll take a (brief) shot at this, maybe this helps. Hopefully you’re graced enough that S2000 chimes in with.

@RaulS

1. Total Return Equity Swap - How money market rate of return (i.e. Rf rate) is being earned on full value of hedged position? Since $100 MM fully hedged value (ABC Corp. example) isn’t actually invested in money market .

The swap exchanges the returns on your risky stock position for a money market rate of return. Gains/losses on the stock are paid/received to/from the counterparty, in exchange for the money market rate of return spelled out in the terms of the contract.

@RaulS

2. Forward conversion with Options - similar to above on how money market rate of return is being earned? If either one of long put or short call option is exercised - wouldn’t investor have to deliver (effectively selling) his/her 1 MM ABC long share holding to fulfill obligation - hence investor not owning stock anymore?

Think about Put-Call Parity. S + P = C + Ke^-rT. We then have that S + P - C = Ke^-rT. Now, the left hand side looks like your long position with a forward conversion with options (i.e., long put, short call, struck both at K expiring at T). By PCP, that’s equivalent to holding a position of Ke^-rT dollars in the risk-free asset, with a maturity payoff of K. So your position between t = 0 and t = T will earn risk-free rate of return.

@RaulS

3. Equity Forward Sale contract - how money market rate is being earned?

Think of the formula for pricing an equity forward contract (supposing non-dividend paying underlying). You’re agreeing to sell your stock at T at the forward price which is the stock’s price today multiplied by e^rT. Effectively you’re selling the stock today and earning the risk-free rate until the maturity payoff at time = T.

In none of the cases are you “actually” holding a money market instrument, but your position in the derivative contracts effectively makes it one. Hope that helps

S2, That U?

Yup.

[S2000magician]

@Black8Mamba23

I’ll take a (brief) shot at this, maybe this helps. Hopefully you’re graced enough that S2000 chimes in with.

@RaulS

1. Total Return Equity Swap - How money market rate of return (i.e. Rf rate) is being earned on full value of hedged position? Since $100 MM fully hedged value (ABC Corp. example) isn’t actually invested in money market.

The swap exchanges the returns on your risky stock position for a money market rate of return. Gains/losses on the stock are paid/received to/from the counterparty, in exchange for the money market rate of return spelled out in the terms of the contract.

@RaulS

2. Forward conversion with Options - similar to above on how money market rate of return is being earned? If either one of long put or short call option is exercised - wouldn’t investor have to deliver (effectively selling) his/her 1 MM ABC long share holding to fulfill obligation - hence investor not owning stock anymore?

Think about Put-Call Parity. S + P = C + Ke^-rT. We then have that S + P - C = Ke^-rT. Now, the left hand side looks like your long position with a forward conversion with options (i.e., long put, short call, struck both at K expiring at T). By PCP, that’s equivalent to holding a position of Ke^-rT dollars in the risk-free asset, with a maturity payoff of K. So your position between t = 0 and t = T will earn risk-free rate of return.

@RaulS

3. Equity Forward Sale contract - how money market rate is being earned?

Think of the formula for pricing an equity forward contract (supposing non-dividend paying underlying). You’re agreeing to sell your stock at T at the forward price which is the stock’s price today multiplied by e^rT. Effectively you’re selling the stock today and earning the risk-free rate until the maturity payoff at time = T.

In none of the cases are you “actually” holding a money market instrument, but your position in the derivative contracts effectively makes it one. Hope that helps

This all looks good.

Recall that the price of a forward contract is the spot price increased at the risk-free rate, so that’s the rate you earn.

A forward conversion with options is nothing more nor less than a synthetic forward contract.