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Collateralized Swap Valuation The Collateralized swap structure is an option where the client, rather than making an upfront cash payment, puts up collateral instead–in this case in the form of a basket of hedge fund investments. For the most part the option acts as an equity swap, with the client paying the returns on a basket of hedge funds and receiving a spread over Libor, with the notional amount resetting periodically. The value of the collateral affects the current leverage ratio and can trigger re-/de-leveraging or redemption, but otherwise has no affect on the option valuation itself. Nevertheless, to monitor the leverage ratio daily the collateral needs to be MTM daily, and ultimately the dealer’s risk in a situation where the deal must be closed out depends on the closeout value of the collateral. Therefore, although as far and the daily P&L process is concerned, these options will look quite similar to an accreting strike option, from a risk standpoint they are quite different. In particular, a VaR calculation would need to consider the closeout volatility of the collateral as well as the basket, and should be vetted separately from the calculation performed for other options. The underlying equity consists of a basket of hedge funds (and cash and potentially other securities). At any time t within any valuation period starting at T (which are year long in this case), the ‘Equity Amount’ is the sum of dollar changes in basket value since the beginning of the valuation period: Et = ΣΔB, with the sum taken over months since the beginning of the valuation period. Note that an Additional Capital Balance (positive from a re-leveraging and negative from a de-leveraging) will increase or decrease the basket value at any time, but will not directly alter the Equity Amount. It does affect the magnitude of _B as it acts like a larger or smaller investment in the basket, that is, you will have a dollar change amount: ΔB = (B0 + ACB) R where R is the return on the basket. The calculation of the floating payments are performed monthly, with a notional amount N that resets monthly: Nt = N0 + Et, that is, it grows with the dollar growth of the basket, beginning at the starting basket level N0 = B0. Collateralized Swap Valuation |