While the Dow is down a thousand points in the past week, the US Dollar Index has risen 1.2% since then, and 17% since early August. How can the dollar go up while all its underlying assets (so to speak) go down? There’s a logical answer (almost always is), but readers, give us your thoughts and we’ll include a couple in next week’s Map.
Speaking of screwy things, let’s talk equity swaps today. We’d also like to preview equity markets regulation under the Obama regime, and offer a couple sentences on why proprietary trading desks at JP Morgan and Merrill Lynch closed last week...but perhaps one eye-glazing topic at a time is enough. So we’ll save these last two.
IR folks, you’ve heard that “swap” is a four-letter word. While the syntactical accuracy of that claim can hardly be disputed, swaps are just agreements to exchange values. Equity swaps give investors a way to participate in markets without the hassle of buying and selling actual shares, meeting complicated custodial or regulatory requirements in different jurisdictions, addressing tax implications (since swaps are derivatives), and of course, disclosing ownership.
For instance, say your hedge fund, Global Enormous Trading Strategies On Momentum Equities (GETSOME), arranges a swap with Barclays to mirror $50 million worth of the iShares Global Energy Sector Index Fund. GETSOME Hedge Fund pays a fee equal to 25 basis points over LIBOR (London Interbank Offered Rate) and Barclays pays your fund the total return up to specified ceiling, at a set time. Conversely, your fund may owe the interest payment plus additional amounts if the index goes down more than a specified amount.
Normally, it’s a great way for GETSOME Hedge Fund to avoid headaches, control costs and spread out risk, and a good use of balance-sheet resources for Barclays. Problems arise if interest rates go wacky, liquidity and credit fears mount, or stock prices swing dramatically and frequently due to exogenous factors.
Hm. Imagine such a thing. Barclays might owe or be owed outsized amounts, might limit clients’ permitted leverage for these contracts, or might force clients to mark them to market to reduce liabilities – and the same might be true for GETSOME Hedge Fund. Both your fund and the bank might have to sell OTHER assets to make good these troubled swaps – forcing unrelated equities to drop in price. Both you and Barclays might unload swap contracts at discounts. Or write them off because one or the other party can’t meet its bargain, and so defaults.
Thus, equity swaps may affect your equity’s value for risk-management reasons, not fundamental ones. This does not mean swaps are tools of the devil. But when values become uncertain, ripples hit related instruments and relationships. IR practitioners, these imbalances do manifest themselves in market structure behavior, and it’s important to differentiate risk-management drivers from fundamental ones, lest you blame your loyal holders for selling your stock when they’re not doing so.
Margaret E. Wyrwas - Knight Capital Group, Inc. (Nasdaq: NITE)
Senior Managing Director, Corporate Communications & Investor Relations
Equity Analysis™ subscriber since March 2007
"In global markets driven by automation, changing market structure regulation and dynamic investment objectives, today's investor relations professionals require new data points in order to remain relevant and add value in their company's quest to reduce its cost of capital."
