MASAAIU KJJIMA This article considers the pricing ofequity swaps with with conrtant notional principal is also deter
is on the faculty of constant and variable notional priruipal in a stochas mined only through the current term struc
Economics at Kyoto tic interest rate economy. Unlike the deterministic ture of interest rates.
University in Kyoto,
interest rate case, the pricing formulas include COY This result is counterintuitive and has
Japan.
relation between interest rates and the equity price puzzled practitioners for many years, since
YWO process, which justifies the practitioners’ belief that equity prices have no impact on the swap rate.
MUROMACHI equity prices a$ect the valuc qf an equity swap by Chance and k c h [1998] show that, in a deter
is with NL.1 Research some means. ministic interest rate economy, this conclusion
Institute in Tokyo. is true only when the rate is set at the start of
The key tool in derivation ofthqformulas is thefor the contract. Thus, the puzzle has been
wardneutral method. The valuation Ofcapped equity resolved in part.
swaps in the stochastic interest economy is also Another question then arises as to
described. whether the equity swap rate, when the rate
is set at the start, is indeed independent of the
swap is an agreement between two equity price process even in the case of vari
SUh4MF.R 2001 19
THEJOURNAL OF DERIVATIVES
belief that equity prices affect the value of the equity swap.
We use the stochastic interest rate economy intro a ( t ,T ) =  1T
y ( t . u)du. t5T
duced by Amin and Jarrow [1992]. In order to derive
closedform solutions for the value of equity swaps, we Here, zl(t) and z2(t) denote the standard Wiener pro
assume that the volatility of interest rates as well as that cesses, assumed to be mutually inde~endent.~ Note that
of the equity price process is deterministic, making our the covariance between the stock price and forward rate
economy Gaussian. Although the interest rates then processes is introduced by the same Wiener process z,(t),
become negative with positive probability, the probabil which is given by
ity is often neghgble, and the benefit in analpcal tractabil
ity is considerable. In fact, we can obtain closedform
solutions for various equity swap rates in the Gaussian
interest rate model.
Our model covers the cases of constant and variable
notional principal, and capped equity swaps and other The time t price of the discount bond maturing at
types of equity swaps considered in Chance and Rich time T is given by
[1998]. It is shown that the equity swap rate with con
stant notional principal, when setting the rate at the start,
is determined only through the current term structure of
interest rates even in the stochastic interest rate economy,
while it depends on the equity price process in the case
of variable notional principal. Explicit formulas for for and the spot interest rate is r(t) = f(t,t). The money mar
wardstart European option prices are obtained, from ket account is defined by
which we can evaluate the value of capped equity swaps
analytically.' Finally, the impact of correlation on the
swap rates is examined through numerical experiments.
I. THE ECONOMY
Hence, the SDEs (1) and (2) suffice to construct our
We consider the stochastic interest rate economy economy.
introduced in Amin and Jarrow [19921. Namely, under the Later, we consider the Gaussian interest rate econ
riskneutral probability measure P", the time t price of omy in order to obtain closedform solutions for various
the risky asset, denoted by S(t),and the instantaneous for equity swap rates. Although the interest rates become
ward rate at time t for date T, denoted by f(t,T), evolve negative with positive probability, the probability is often
according to the stochastic differential equations: neghglble, and there is a great benefit in analytical tractabil
ity. Hence, we assume that the ol(t), i = 1, 2, in (1) are
constant (oi(t) oi,say), and that
az(t)d&). t 20
for some deterministic hnction K(t).4 It follows from
and Ito's formula that
( T) +
d l n S ( t ) = r ( t )   dt
+ J’ b(s)dB(O,s) t
C ( t )= C ( 0 )
0
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C*(t)= C*(O) + J" O(s)dS*(s),
0
t5T
Hence, if S*(t) is a martingale under some proba Hence, if S,(t) is a martingale under some proba
bility measure (in fact, it is a martingale under the risk bility measure, PT, say, the forward price process C,(t) is
neutral measure P"), the relative price process C*(t) is also also a martingale. Denoting the expectations operator
a martingale. Denoting the expectations operator under under PT by E', it follows that
P* by E*, it follows that
= C*(O)= C( 0 )
E*[C*(T)]
whence, since C,(T) = C(T) = X, we obtain
whence, since C*(T) = C(T)/B(O, T) = X/B(O, T), we
obtain C(0)= w(0, T ) E T [ X ]
and
Other forward prices are defined similarly. Then,
since v,(t, T) = 1 for all t, we have
provided that a(<,’T) f a(t, T), which rules out the deter
ministic interest rate case. Also, under the fonvardneu
T<7 tral measure PT, the forward processes S,(t) and vT(t, Z)
satisfjr the SDEs:
where pS(t,T) = (a’(t, T)  0’)/2, 0’I Of + 05, and
(t, T, 2) = [a’(t, T)  a”t, T ) I / ~ .It follows fiom Ito’s for
mula that dST (t)
  (01  a(t. T ) ) d z T ( t )+ ‘
ST ( t )
and
and
and
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OF DERIVATIVES
Let us denote the relative price by S*(t) = S(t)/B(O,
t). Then:
= S*(O)= S(O), t 2 0
E,*[S*(t)] (14)
we have
2 2 2
= E,[s*(t71)2l(tz~,ti)],
it follows that
where zT(t), i = 1, 2, are mutually independent, standard
Wiener processes under the forwardneutral measure P'.
O n the other hand, from Theorem 1, we obtain
to 1. 0 (17)
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2001 25
THEJOURNAL OF DERIVATIVES
for the value of capped equity swaps with constant or vari
able notional principal in the Gaussian interest rate econ
omy. Throughout, we denote the cap rate per period by
K, which is a constant over the life of the swap.
(1 + R ) ~ f ( O , t l )to, 5 0 (20)
Notice that correlation between the interest rates and
the equity price process is implicit through the term
c(t, T, 2 ) . In fact, ifthe interest rates are deterministic, then where we denote X 3 K + 1. Note that the first term in
and <(t,T, 2) is equal to unity, equation (20) becomes iden (22) is identical to the cash flow of the equity swap with
tical to (18).Also, if CT, = 0, i.e., the equity price process constant notional principal, while the second term is that
and the interest rates are uncorrelated, then the term of the forwardstart European call option with maturity
c(t, T, 2) is a hnction of parameters of interest rates alone. ti, strike price X, and starting date ti
Finally, we note that various types of equity swaps con Let us denote the price of the forwardstart Euro
sidered in Chance and Rich [1998] can also be easily eval ,, ,
pean call option by c(ti ti, X), 0 Iti < ti. From The
uated using (20). orem 1 we obtain
If, in particular, the swap rate is set at the start of the
contract, i.e., to = 0, then we have
c(ti1, ti, X)= v(0,ti) x
since V’(0, tm) = 0. The swap rate R in this case does Using the forwardneutral method, we have the
depend not only on the current term structure of inter result as follows (proof is given in Appendix A).
est rates but also on the stock price process, via o1if o1 Theorem 2. In the Gaussian interest rate economy,
f 0, that is,‘ifthe equity price process is correlated with the price of the forwardstart European call option is
the interest rates. given by
with
I.
+RI]
[ S(
E$ S(t,l)max  {
s ( tt,1)
z)  x,o}]
we have the result in proposition 1.
Proposition 1. The present value of the capped
equity swap with constant notional principal is given by
The validity of this definition is verified by (27) and
Theorem 1 . Note the difference between (28) and (23).
Using a similar but more complicated argument than
Theorem 2, we have the result in Theorem 3 (proof is
given in Appendix B).
Theorem 3. In the Gaussian interest rate economy,
m the price of the forwardstart European call option is
given by6
i=l
R= m
where 0%is given in Theorem 2, and where
Y (1  e " ( T  t ) )
a ( t ,T ) = 
6
V. NUMERICAL EXAMPLES swap. The effect of C T ~on the value diminishes as the cap
rate increases or the maturity shortens. Although these
Some numerical examples help us investigate the graphs look very similar, the effect of oI on the value in
impact of correlation between interest rates and the equity the variable notional principal case is greater than that in
price process on equity swap rates. Recall that the swap the constant notional principal case.
E X H I B I T1
Swap Rates for Equity Swaps WO)
E X H I B I T2
Term Structures of Swap Rates for Equity Swaps
6.0%
 IS
*30.0%
5.5% 
+ 200%
*10
10
0%
0.0%
0%
20.0%
~ + 30.0%
4.0%
3.5%
3.0% . ~ . ~~.
. ..~ ~~.
0 1 2 3 4 5 6 7 8 9 10
Maturity
777cjigure depicts the resu1t.c in Exhibit 1. “IS” mean thc swap ratesfor the plain vanilla interestrate swap, and the rates are equal to those in the constant
notional principal case.
Finally, we calculate the swap rates for capped equity For example, in the case of the constant notional
swaps accordmg to (26) and (30). Exhibits 5 and 6 show principal with tm = 5 and o1= 0.1, if the cap rate is lower
the swap rates for the constant and variable notional prin than 19.7%,the present value of the capped equity swap is
cipal cases. As the cap rate or the maturity increases, the negative, even for the case that R= 0. It is observed that the
swap rate rises. When the cap rate is too low, the present swap rate rises as o1is reduced in the constant notional prin
value of a capped equity swap is negative on the tixed side, cipal case (see Exhibit 5), but such a relation fails in the vari
so that the swap rate becomes negative. able notional principal case when the cap rate is high and
the maturity is long (see Exhibit 6). The dIfZerence between
0, i
0.1
0.2
0.3
Q)
0
*= 0.4
n
v
0.5
0.6
0.7


 ___
sigrnal =O%
srgrnal=O%
sigrnal=O%
sigrnal=lO%
1
Maturity = 1Oy 1

 si rnal=100/
sitmat = l o J
0.8 1 1
EXHIBIT4
Present Values of Capped Equity Swaps with Variable Notional PrincipalProposition 2
0
Maturity = 2y
0.1
0.2
0.3
Q) 0.4
.0
0.5
0.6
0.7
. _
.. ..
0.8
0.9
... . ...  1
1 I 1
0O h 5% 10% 15% 20%
5.0%
4.0%
a
CI
m 3.0%
w
Q.
m
$ 2.0%
.    
+ sigmal =O%
+ sigmal=O%
+sigmalEO%
1.O% 
sigma1=10%
sigrnal=lO%
sigma~=~~%
 
0.0%
0Yo 20% 40% 60% 80% 100%
Cap Rate
The swap rates are calculated based on (26). The parameters are set to be the same as in Exhibit 3 . T h e swap rate increases as 6,decreases.
E X H I B I T6
Swap Rates for Capped Equity Swaps with Variable Notional PrincipalEquation (30)
6.0% 1 I
5.0%
4.0%
3.0%
2.0%
1 .O%
0.0%
0% 20% 40% 60% 80% 100%
Cap Rate
T h e swap rates are calculated based on (30). The parameters are set to be the same as in Exhibit 4. The suiap rate does not aluiays increase as (T,
decreases in
contrast to Exhibit 5.
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the two cases comes from c(0, ti  ti) in (30), which
depends on al.
A P P E N D I XA
Proof of Theorem 2
(A3)
= 0 (A4
Similarly, by the change of variables U and s, we obtain
whose proof is gk7en below. Now. (A3) means that x = In
[S(tJ/S(t, is normally distributed Lvith mean p, and vari
ance 01. where
and
It follows that
APPENDIX
B
Proof of Theorem 3
where
and
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THEJOURNAL OF DEKIVATIVES
E: [f(Z  C [ Y ,Z ] ) ]=
Then:
and
= [(O.
1
1
 V [ Y ]  SC[X.Y ]
2
G2 [ X ] }
Hence, (A3) and (€32) together imply that Z  C p , Z ]
+
is normally distributed with mean 1.1, ~ ( 0tl, tJ and vari
ance 0;.It follows that
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