Equity Swap Spreads

[Osmith1]

On the interest rate leg of an equity swap there is often a spread paid over the reference rate eg. 3M LIBOR. Should these spreads be considered as a risk factor and an input to a VaR model?

 

[ShaktiRathore]

The libor leg has a spread which reflects credit risk as there is some credit risk involved in equity swap i.e. as equity risk is an agreement there is some risk that other part that has floating rate obligation might not be able to fulfill the obligation which is nothing but the credit risk. There is market risk associated with the libor rate so we calculate the market risk VaR. The other party can always enter into CDS contracts to mitigate the credit risks associated with equity swap, so that one dont needs to incorporate the spread into the VaR calculation.However there is always some risk in the credit spread which should be taken into account while calculating the VaR but i am not sure whether it is done. From my side this is my explanation that i can give you.

thanks

 

[Osmith1]

The libor leg has a spread which reflects credit risk as there is some credit risk involved in equity swap i.e. as equity risk is an agreement there is some risk that other part that has floating rate obligation might not be able to fulfill the obligation which is nothing but the credit risk. There is market risk associated with the libor rate so we calculate the market risk VaR. The other party can always enter into CDS contracts to mitigate the credit risks associated with equity swap, so that one dont needs to incorporate the spread into the VaR calculation.However there is always some risk in the credit spread which should be taken into account while calculating the VaR but i am not sure whether it is done. From my side this is my explanation that i can give you.

thanks

Thank you for your explanation. I was some what curious as to whether the spread is also driven by the costs associated with borrowing the underlying equities so as to be able to hedge/provide the performance of the swap on the equity leg. Could that also be a contributing factor?

 

[ShaktiRathore]

I don't know if that is a contributing factor. Under equity swap the equity leg provides the return on the equity. And if the borrowing costs of equity is considered as a factor is uncertain. i dont think borrowing costs are considered if at all.

thanks