Handbook of Corporate Equity Derivatives and Equity Capital Markets
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1 Main Strategic Equity Derivative Instruments 1
1.1 Equity Forwards 1
1.1.1 Equity Forwards 1
1.1.2 Example of a Cash-settled Equity Forward on a Stock 2
1.1.3 Example of a Physically Settled Equity Forward on a Stock 3
1.1.4 Calculating the Forward Price of a Stock 4
1.2 Equity Swaps 6
1.2.1 Total Return Equity Swaps 6
1.2.2 Price Return Equity Swaps 7
1.2.3 Case Study: Physically Settled Total Return Equity Swap on Deutsche Telekom 7
1.2.4 Case Study: Cash-settled Total Return Equity Swap on Deutsche Telekom 12
1.2.5 Determination of the Initial Price 15
1.2.6 Determination of the Settlement Price 16
1.2.7 Equity Notional Resets 17
1.2.8 Case Study: Total Return Equity Swap on EuroStoxx 50 17
1.2.9 Compo Equity Swaps 21
1.2.10 Quanto Equity Swaps 23
1.2.11 Uses of Equity Swaps 25
1.3 Stock Lending and Borrowing 26
1.3.1 Stock Lending and Borrowing 26
1.3.2 Stock Lending/Borrowing Transaction Flows 27
1.3.3 Counterparty Credit Risk 28
1.3.4 Advantages of Stock Lending and Borrowing 29
1.3.5 Drawbacks of Stock Lending and Borrowing 29
1.4 Call and Put Options 30
1.4.1 Call Options 30
1.4.2 Put Options 33
1.4.3 European vs. American Style 36
1.4.4 Time Value vs. Intrinsic Value 36
1.4.5 In, At or Out-of-the-money 37
1.4.6 Variables that Influence an Option Price 38
1.4.7 Historical Volatility vs. Implied Volatility 40
1.4.8 Put-Call Parity 41
1.4.9 Options' Sensitivities, the "Greeks" 42
1.4.10 Delta Hedging 44
1.4.11 Offsetting Dividend Risk 45
1.4.12 Adjustments to Option Terms Due to Other Corporate Actions 46
1.4.13 Volatility Smile 47
1.4.14 Implied Volatility Term Structure 48
1.4.15 Composite and Quanto Options 49
1.5 Dividend Swaps 50
1.5.1 Dividend Swaps 50
1.5.2 Applications of Dividend Swaps 50
1.5.3 Risks 52
1.5.4 Main Dates in a Dividend Distribution 52
1.5.5 Case Study: Single-stock Dividend Swap 52
1.5.6 Case Study: Index Dividend Swap 56
1.5.7 Pricing Implied Dividends 58
1.6 Variance Swaps and Volatility Swaps 58
1.6.1 Variance Swaps Product Description 59
1.6.2 Calculation of the Realized Volatility and the Realized Variance 61
1.6.3 Volatility Swaps Product Description 62
1.6.4 Volatility Swaps vs. Variance Swaps 63
1.6.5 Applications of Variance and Volatility Swaps 63
2 Equity Capital Markets Products 65
2.1 Main Equity Capital Markets Products 65
2.1.1 Capital Increase Products 65
2.1.2 Secondary Placement Products 66
2.1.3 Equity-linked Products 66
2.2 Initial Public Offerings 66
2.2.1 Product Description 66
2.2.2 Benefits of Going Public 67
2.2.3 Drawbacks of Going Public 67
2.2.4 The IPO Process 68
2.2.5 Phase 1: Preparation of the Company 68
2.2.6 Phase 2: Preparation of the Offering 69
2.2.7 Phase 3: Marketing of the Offering 75
2.2.8 Phase 4: Placement of the Offering 77
2.2.9 Key Success Factors Affecting an IPO 80
2.2.10 Key Risk Factors Affecting an IPO 81
2.2.11 Case Study: Visa's IPO 82
2.3 Case Study: Google's Dutch Auction IPO 85
2.4 Rights Issues (or Rights Offerings) 87
2.4.1 Product Description 87
2.4.2 Main Definitions of a Rights Issue 88
2.4.3 Advantages and Weaknesses of a Rights Issue 89
2.4.4 Rights Offerings Success Factors 90
2.4.5 Calculation of the TERP 90
2.4.6 Case Study: ING's EUR 7.5 billion Rights Issue 91
2.5 Rights Issues of Convertible Bonds 95
2.5.1 Case Study: Banco Popolare Rights Issue of a Convertible Bond 95
2.6 Accelerated Book-Buildings 98
2.6.1 Product Description 98
2.6.2 Advantages and Weaknesses of an ABB 99
2.6.3 Estimating the Discount 99
2.6.4 Case Study: IPIC's Disposal of 11.8% of Barclays 100
2.7 At the Market Offerings 100
2.7.1 Product Description 100
2.7.2 Case Study: US Treasury Placement of Citigroup Shares 101
3 Convertible Bonds and Mandatory Convertible Bonds 103
3.1 Introduction to Convertible Bonds 103
3.1.1 What are Convertible Bonds? 103
3.1.2 Convertible vs. Exchangeable Bonds - Exchange Property 104
3.2 Who Buys Convertible Bonds? 105
3.3 Convertible Bonds: The Issuer Perspective 106
3.4 Case Study: Infineon's Convertible Bond 107
3.4.1 Main Terms of Infineon's Convertible Bond 107
3.4.2 Conversion Price, Ratio, Premium and Lockout Period 108
3.4.3 Hard No Call Period, Hard Call and Soft Call Options 109
3.4.4 Put Rights 110
3.4.5 Additional Clauses: Cash Option, Cash Top-up, Lock-up Period, Tax Call 111
3.4.6 Value of a Convertible Bond at Maturity 112
3.4.7 Value of a Convertible Bond during its Life 112
3.5 Delta Share Repurchase Strategy 114
3.6 Mandatory Convertible Bonds 115
3.7 Rationale for Issuing Mandatory Convertibles 115
3.8 Rationale for Investing in Mandatory Convertibles 116
3.9 Fixed Parity Mandatory Convertibles 116
3.9.1 Case Study: Banco Santander's Fixed Parity Mandatory Convertible 116
3.10 Variable Parity Mandatory Convertibles 118
3.11 Dividend Enhanced Convertible Securities 118
3.11.1 Conversion Mechanics of a DECS 118
3.11.2 Anatomy of a DECS 120
3.11.3 Embedded Derivatives in a DECS 121
3.11.4 Pricing a DECS 122
3.12 Case Study: UBS's DECS 122
3.13 Special Clauses in Convertibles 124
3.13.1 Dividend Protection Clauses 124
3.13.2 Coupon Deferral Clauses 125
3.13.3 Call Option Make-whole Clauses 126
3.13.4 Change-of-control Make-whole Clauses 126
3.13.5 Clean-up Call Clauses 127
3.13.6 Net Share Settlement Clauses 127
3.14 Contingent Convertibles: FRESHES, CASHES and ECNS 127
3.14.1 Case Study: Fortis's FRESH Instrument 128
3.14.2 Case Study: Unicredit's CASHES Instrument 131
3.14.3 Case Study: Lloyds ECN 136
3.14.4 Case Study: Rabobank's SCN 139
4 Strategic Equity Transactions around Convertible/Exchangeable Bonds 141
4.1 Issuing an Exchangeable with a Third-party Guarantee 141
4.1.1 Case Study: Controlinveste's Exchangeable Bonds on Portugal Telecom 141
4.1.2 Transaction Overview 142
4.1.3 Dividend Swap and Transaction Flows during the First Four Years 143
4.1.4 Transaction Flows in Case of Exchanges or at Maturity 145
4.1.5 Exchange Property Pledge and other Security Mechanisms 146
4.1.6 Attractiveness of the Transaction to the Issuer and to BCP 147
4.2 Issuing a Convertible Through a Third Party 147
4.2.1 Case Study: Novartis LEPOs and Put Options with Deutsche Bank 147
4.2.2 Transaction Overview 147
4.2.3 Deutsche Bank's Exposure to Novartis's Stock Price 149
4.2.4 Effect of Deutsche Bank's Zero-coupon Convertibles on the Exchange Price 151
4.2.5 Attractiveness of Deutsche Bank's Zero-coupon Exchangeables to Investors 152
4.2.6 Advantages to Novartis and Relevance of a Call Right 152
4.3 Crystallizing a Gain in a Convertible Investment Through Warrants 153
4.3.1 Case Study: Richemont Warrants Issue on Back of Convertible Preference Shares 153
4.3.2 Warrants' Terms 154
4.3.3 Analysis of R&R's Position 154
4.3.4 Main Benefits to Richemont of the Warrants Issue 155
4.3.5 Effect on BAT's Stock Price of the Warrants Issue 156
4.4 Monetizing a Stake with an Exchangeable Plus a Put 156
4.4.1 Case Study: Deutsche Bank's Exchangeable into Brisa 156
4.4.2 Transaction Overview 157
4.4.3 Analysis of Deutsche Bank's Overall Position 158
4.5 Increasing Likelihood of Conversion with a Call Spread 161
4.5.1 Case Study: Chartered Semiconductor's Call Spread with Goldman Sachs 161
4.5.2 Goldman Sachs's Overall Position 162
4.5.3 CSM's Overall Position 163
4.5.4 Attractiveness of the Transaction to CSM 166
4.5.5 Additional Remarks 167
4.6 Decreasing Likelihood of Conversion with a Call Spread 169
4.6.1 Case Study: Microsoft's Convertible Plus Call Spread 169
4.7 Double Issuance of Exchangeable Bonds 169
4.7.1 Case Study: ABC's Double Exchangeable 169
4.8 Buying Back Conversion Rights 172
4.8.1 Case Study: Cap Gemini's Repurchase of Conversion Right from Société Générale 172
4.9 Buying Back Convertible/Exchangeable Bonds 175
4.9.1 Case Study: TUI's Convertible Bond 175
4.10 Pre-IPO Convertible Bonds 178
5 Hedging and Yield Enhancing Strategic Stakes 181
5.1 Hedging a Strategic Stake 181
5.1.1 Hedging with a Put Option 181
5.1.2 Hedging with a Put Spread 184
5.1.3 Hedging with a Collar 186
5.1.4 Hedging with a Put Spread Collar 188
5.1.5 Hedging with a Fly Put Spread 189
5.1.6 Hedging with a Knock-out Put 191
5.1.7 Summary of Main Hedging Strategies 193
5.1.8 Hedging with Ladder Puts 193
5.1.9 Hedging with Variable Premium and Variable Expiry Timer Puts 195
5.1.10 Hedging with Pay-later Puts 197
5.2 Yield Enhancement of a Strategic Stake 199
5.2.1 Lending the Stock 199
5.2.2 Selling Part of the Upside with a Call 200
5.2.3 Monetization of Dividend Optionality 202
5.2.4 Reduction of Dividend Withholding Taxes with a Stock Lending Strategy 204
5.2.5 Reduction of Dividend Withholding Taxes with a Converse Strategy 205
6 Disposal of Strategic Stakes 207
6.1 Most Common Disposal Strategies 207
6.1.1 Case Study Assumptions 207
6.1.2 Market Dribbling Out or Gradual Sale 208
6.2 Deterministic Disposal Strategies 209
6.2.1 ABB - Block Trade 209
6.2.2 Mandatory Exchangeable Bond 211
6.2.3 Indirect Issue of an Exchangeable Bond 211
6.3 Enhanced Disposal Strategies 212
6.3.1 Direct Issue of an Exchangeable Bond 213
6.3.2 Sale of a Call Option 214
6.3.3 One-speed Range Accrual 216
6.3.4 Double-speed Range Accrual 220
6.3.5 Double-speed Range Accrual with Final Call 221
6.3.6 Double-speed Range Accrual with Deduction 222
6.3.7 Double-speed Range Accrual with Knock-out 222
6.4 Derecognition Strategies 224
6.4.1 Sale + Cash-settled Equity Swap 224
6.4.2 Physically Settled Equity Swap + Call Option 227
6.5 Combination of ABB and a Call Option/Exchangeable 229
6.5.1 Case Study: Germany's Disposal of Fraport with JP Morgan's Collaboration 229
7 Strategic Equity Derivatives in Mergers and Acquisitions 235
7.1 Keeping Voting Rights in Proxy Contests 237
7.1.1 Case Study: Montalban Partners' Disposal of Gold International 237
7.2 Submitting Resolutions to an AGM 239
7.2.1 Case Study: Laxey's Stock Lending Transaction 240
7.3 Increasing Likelihood of Success of a Merger Arbitrage Position 242
7.3.1 Case Study: Perry's Equity Swaps with Bear Stearns and Goldman Sachs 242
7.4 Avoiding Mandatory Offer Rules 247
7.4.1 Case Study: Agnelli Family Equity Swap with Merrill Lynch 247
7.5 Increasing Likelihood of Success of a Takeover 251
7.5.1 Case Study: Unipol's Takeover of BNL and Call/Put Combination with Deutsche Bank 251
8 Stock Options Plans Hedging 257
8.1 Main Equity-based Compensation Plans 257
8.1.1 Main Equity-based Compensation Plans 257
8.1.2 Terminology of Stock Option Plans and SARs 258
8.2 IFRS Accounting for Equity-based Compensation Plans 259
8.2.1 Accounting for Stock Options Plans 261
8.2.2 Accounting for Stock Appreciation Rights 263
8.3 Case Study: ABC's ESOP and SAR 265
8.3.1 Main Terms of ABC's ESOP and SAR 265
8.3.2 Accounting for ABC's ESOP 266
8.3.3 Accounting for ABC's SAR 270
8.4 Main ESOP/SAR Hedging Strategies 273
8.4.1 Underlying Risks in ESOPs and SARs 273
8.4.2 Hedging with Treasury Shares 274
8.4.3 Hedging with Equity Swaps 275
8.4.4 Hedging a SAR with an Enhanced Equity Swap 279
8.4.5 Hedging with Standard Call Options 280
8.4.6 Hedging with Auto Call Options 282
8.4.7 Hedging with Timer Call Options 282
8.5 HSBC's Performance Share Plan 283
8.5.1 Terms of HSBC's Performance Share Plan 283
8.5.2 Accounting for the Plan 284
8.5.3 Hedging the Plan 285
9 Equity Financings 287
9.1 Case Study: Equity Collateralized Bond 287
9.1.1 Bond Terms 287
9.1.2 Main Documents of the Financing 288
9.1.3 Parties to an Equity Financing 289
9.1.4 Accounts in an Equity Financing 290
9.1.5 Credit Enhancement Tools 291
9.1.6 Early Termination Events 292
9.1.7 Events of Default 295
9.1.8 Syndicating the Equity Financing with a Credit Default Swap 297
9.1.9 Recourse vs. Non-recourse Equity Financings 299
9.2 Sale + Equity Swap 300
9.2.1 Transaction Description 300
9.2.2 Equity Swap Terms 300
9.2.3 Equity Swap Flows 305
9.2.4 Advantages and Weaknesses 307
9.3 Prepaid Forward + Equity Swap + Pledge 308
9.3.1 Product Description 308
9.3.2 Equity Derivatives Terms 308
9.3.3 Transaction Flows 314
9.3.4 Advantages and Weaknesses 316
9.4 Repo Financing 316
9.4.1 Product Description 316
9.5 Stock Loan Financing 317
9.5.1 Product Description 317
9.6 Put Financing 318
9.6.1 Product Description 318
9.6.2 Advantages and Weaknesses 319
9.7 Collared Financing 320
9.7.1 Product Description 320
9.7.2 Advantages and Weaknesses 321
9.8 Revolving Margin Loan Facilities 322
9.8.1 Case Study: Oil SPE's Revolving Margin Loan Facility 322
10 Share Buybacks and Other Transactions on Treasury Shares 327
10.1 Open Market Repurchase Programs 327
10.2 Accelerated Repurchase Programs 329
10.2.1 Case Study: Hewlett Packard's ASR with Merrill Lynch 329
10.3 VWAP-Linked Repurchase Programs 332
10.3.1 Execution on a Best Effort Basis 332
10.3.2 Execution on a Guaranteed Basis 333
10.3.3 Advantages and Weaknesses of a VWAP-linked Strategy 333
10.3.4 Execution at a Discounted VWAP 334
10.3.5 Execution at a Capped VWAP 337
10.4 Prepaid Collared Repurchase Programs 338
10.4.1 Case Study: Hewlett Packard's PCRP with BNP Paribas 339
10.5 Deep-in-the-money Call Purchase 340
10.5.1 Case Study: ABC's Acquisition of a Deep-in-the-money Call Option 341
10.6 Asian Call Purchase 343
10.7 Publicly Offered Repurchase Programs 345
10.7.1 Case Study: Corporacion Dermoestetica's Public Offer to Acquire Own Shares 345
10.8 Public Offer of Put Options 346
10.8.1 Case Study: Swisscom's Public Offer of Put Options 346
10.9 Private Sale of a Put Option 347
10.10 Acquisition of Shares with a Range Accrual 348
10.10.1 One-speed Range Accrual 348
10.10.2 Double-speed Range Accrual 352
10.10.3 Double-speed Range Accrual with Final Put 354
10.11 Other Transactions on Treasury Shares 355
10.11.1 Case Study: ABC's Restructuring of Call on Own Shares 355
10.11.2 Case Study: Gilead's Share Repurchase Program Financed with Convertible Bonds 361
11 Bank Regulatory Capital 365
11.1 An Overview of Basel III 365
11.1.1 Precedent Bank Regulatory Capital Accords 365
11.1.2 The Capital Ratio 366
11.1.3 Bank Regulatory Capital 367
11.1.4 Risk-weighted Assets 367
11.2 Tier 1 Capital 369
11.2.1 Common Equity Tier 1 Capital 369
11.2.2 Additional Tier 1 Capital 373
11.3 Tier 2 Capital 376
11.3.1 Criteria for Inclusion in Tier 2 Capital 376
11.3.2 Trigger Conditions for Hybrid Instruments 379
11.4 Deductions from Common Equity Tier 1 Capital 380
11.4.1 Goodwill and Other Intangible Assets (Except Mortgage Servicing Rights) 380
11.4.2 Deferred Tax Assets 380
11.4.3 Cash Flow Hedge Reserve 382
11.4.4 Shortfall of the Stock of Provisions to Expected Losses 383
11.4.5 Gain-on-sale Related to Securitization Transactions 383
11.4.6 Gains and Losses on Fair Valued Own Liabilities due to Changes in Own Credit Risk 383
11.4.7 Defined Benefit Pension Fund Assets and Liabilities 383
11.4.8 Treasury Stock 385
11.4.9 Reciprocal Stakes in Unconsolidated Financial Companies 385
11.4.10 Less than 10% Stakes in Unconsolidated Financial Companies 385
11.4.11 Significant Stakes in Unconsolidated Financial Companies 387
11.4.12 Combined Deduction of Significant Investments in Unconsolidated Financial Entities, MSRs and DTAs 388
11.4.13 Basel II 50/50 Deductions 389
11.5 Other Capital Buffers 389
11.5.1 Capital Conservation Buffer 389
11.5.2 Countercyclical Buffer 391
11.6 Transitional Arrangements 392
11.6.1 Transitional Period 392
11.6.2 Capital Instruments Failing Criteria for Eligibility in Capital 393
11.7 Leverage Ratio 393
11.8 Liquidity Coverage Ratio 394
11.9 Net Stable Funding Ratio 396
11.10 Case Study: Calculation of Minority Interests 397
11.11 Case Study: Creating Minority Interests 399
11.12 Case Study: Reducing Risk Weighting 401
11.13 Case Study: Releasing Common Equity 401
11.14 Case Study: Reducing an Unconsolidated Financial Stake 403
11.15 Case Study: Commerzbank's Capital Structure Enhancement with Credit Suisse 404
Bibliography 407
Index 409
1
Main Strategic Equity Derivative Instruments
This chapter provides a good understanding of the equity derivative instruments most widely used by equity derivatives professionals. This is the most complex and technical chapter of this book. It aims to solidify the reader's technical knowledge of these instruments. I have also tried to emphasize the practical aspects of these instruments when applied to strategic equity transactions. I start with a discussion of less complex instruments such as equity forwards and equity swaps. I continue covering stock lending transactions – although not derivative instruments, they nonetheless are a key component of strategic equity transactions. Options are addressed next, starting with the basics and progressing to an explanation of option sensitivities and delta-hedging. Finally, I include more specialized equity derivative products such as dividend swaps, variance swaps and volatility swaps.
1.1 EQUITY FORWARDS
1.1.1 Equity Forwards
Equity forwards allow an investor to take bullish or bearish views on an underlying stock, a basket of stocks or a stock index.
- A physically settled equity forward is an agreement between two counterparties whereby one counterparty – the buyer – agrees to buy from the other counterparty – the seller – a specified number of shares of a specified stock or basket of stocks, at a specified time in the future – the settlement date – at a pre-agreed price – the forward price. This instrument is called a physically settled forward, because the underlying shares are delivered by the seller to the buyer. The buyer and the seller pay no upfront premium to enter into the equity forward.
- A cash-settled equity forward is an agreement between two counterparties whereby one counterparty – the buyer – receives at a specified time in the future – the settlement date – from the other counterparty – the seller – the appreciation of the underlying stock, basket of stocks or stock index, above a pre-agreed price – the forward price. Conversely, the seller receives from the buyer the depreciation of the underlying below the forward price. This forward is called a cash-settled forward, because no underlying shares are delivered to the buyer at maturity. Only cash is paid by one party to the other. The buyer and the seller pay no upfront premium to enter into the equity forward.
- Often a forward can be both cash-settled and physically settled, giving one of the two counterparties the right to choose the type of settlement just prior to maturity.
An equity forward agreement is formalized through a confirmation. The confirmation is generally legally subject to the terms and clauses of the International Swaps and Derivatives Association (ISDA) Master Agreement signed between the two counterparties. As its name suggests, once signed, the Master Agreement governs all past and future individual derivative transactions entered into between the two counterparties.
1.1.2 Example of a Cash-settled Equity Forward on a Stock
Let's assume that our entity ABC Corp. has a positive view on Deutsche Telekom (DTE) stock for the next three months. As a result, ABC is considering entering into an equity forward. As seen earlier, a forward can be either physically settled or cash-settled. In a physically settled equity forward the buyer will pay to the seller an amount equal to the forward price multiplied by the number of shares, and the seller will deliver to the buyer the number of shares. In a cash-settled forward the appreciation or depreciation of the shares relative to the forward price is exchanged between the two counterparties. Because ABC is not interested in receiving DTE shares at maturity, ABC enters into a 3-month cash-settled equity forward on 10 million shares of DTE, with the following terms:
Equity Forward Main Terms Buyer ABC Corp. Seller Gigabank Trade date 20-September-20X1 Shares Deutsche Telekom Number of shares 10 million Forward price EUR 15.00 Settlement price The closing price of the shares on the valuation date Valuation date 20-December-20X1 Exchange Eurex Settlement method Cash settlement Cash settlement amount The absolute value of:With the convention that:
Settlement date 23-December-20X1 (three exchange business days after the valuation date)
During the life of the equity forward, the flows between the two counterparties are the following.
At inception, the forward agreement is signed by the counterparties. No flows take place, as the buyer and the seller pay no upfront premium to enter into the equity forward.
Until maturity of the forward, no flows take place.
At maturity, the “settlement price” will be calculated on the “valuation date”. In this example, the settlement price is the closing price of DTE stock on 20 December 20X1 (i.e., the valuation date). Immediately after, the “cash settlement amount” will be calculated as the absolute value of the product of (i) the “number of shares” and (ii) the difference between the settlement price and the forward price. Three potential scenarios may take place:
- If DTE stock has appreciated relative to the forward price (i.e., the settlement price is greater than the forward price), ABC would receive from Gigabank the stock appreciation times the number of shares (i.e., the cash settlement amount) on the settlement date.
- Conversely, if DTE stock has depreciated relative to the forward price (i.e., the settlement price is lower than the forward price), ABC would pay to Gigabank the stock depreciation times the number of shares (i.e., the cash settlement amount) on the settlement date.
- If DTE stock has ended up at the same level as the forward price (i.e., the settlement price is equal to the forward price), no cash flows take place.
Let us assume that on the valuation date (20 December 20X1), DTE stock closes at EUR 18.00. The settlement price would then be EUR 18.00. ABC would receive from Gigabank EUR 30 million [= 10 million shares × (18.00 – 15.00)] on the settlement date (23 December 20X1).
Let us assume instead that on the valuation date (20 December 20X1), DTE stock closes at EUR 13.00. The settlement price would then be EUR 13.00. ABC would pay to Gigabank EUR 20 million [= 10 million shares × (15.00 – 13.00)] on the settlement date (23 December 20X1).
Figure 1.1 shows the profit or loss to ABC as a function of DTE's stock price at maturity. Therefore, DTE's maximum profit is unlimited while its maximum loss is limited to EUR 150 million (= 10 million shares × 15.00) reached if DTE's stock price is zero at maturity.
Figure 1.1 Equity forward payoff at maturity.
1.1.3 Example of a Physically Settled Equity Forward on a Stock
Let us assume that our entity, ABC Corp., plans to acquire 10 million shares of Deutsche Telekom (DTE) in three months’ time. ABC is worried that DTE's stock price might increase during the next three months. As a result, ABC enters into a physically settled forward on 10 million shares of DTE, with the following terms:
Equity Forward Main Terms Buyer ABC Corp. Seller Gigabank Trade date 20-September-20X1 Shares Deutsche Telekom Number of shares 10 million Forward price EUR 15.00 Exchange Eurex Settlement method Physical settlement Settlement date 23-December-20X1During the life of the equity forward, the flows between the two counterparties are the following.
At inception, the forward agreement is signed by the counterparties. No flows take place, as the buyer and the seller pay no upfront premium to enter into the equity forward.
Until maturity of the forward, no flows take place.
At maturity, “on the settlement date”, the buyer – ABC – will pay to the seller – Gigabank – an amount equal to the forward price multiplied by the number of shares, and the seller – Gigabank – will deliver to the buyer – ABC – the number of shares of DTE, as shown in Figure 1.2. In other words, ABC will pay EUR 150 million (= 10 million × 15.00) in exchange for 10 million shares of DTE.
Figure 1.2 Physically settled equity forward, settlement at maturity.
1.1.4 Calculating the Forward Price of a Stock
The easiest way to calculate a forward price of a stock is to come up with a riskless strategy, like the following:
- At inception, we buy one share of the stock paying the then prevailing stock price (i.e.,...
