Pricing Equity Swaps in a
Stochastic Interest Rate Economy
MASAAKI
KIJIMAAND YUKIO MUROMACHI
MASAAIU KJJIMA This article considers the pricing ofequity swaps with
is on the faculty of constant and variable notional priruipal in a stochas-
Economics at Kyoto tic interest rate economy. Unlike the deterministic
University in Kyoto,
interest rate case, the pricing formulas include COY-
Japan.
relation between interest rates and the equity price
YWO process, which justifies the practitioners’ belief that
MUROMACHI equity prices a$ect the valuc qf an equity swap by
is with NL.1 Research some means.
Institute in Tokyo.
The key tool in derivation ofthqformulas is the-for-
ward-neutral method. The valuation Ofcapped equity
swaps in the stochastic interest economy is also
described.
swap is an agreement between two
A parties to exchange cash flows in the
future according to a prearranged
formula. The most conmon types of
swaps are interest rate swaps and currency swaps.
Among them, equity swaps are also common
in a variety of situations for practitioners, where
party A agrees to pay party I3 cash flows equal
to the return on a stock or equity index for a
number of years and, at the same time, party B
promises to make either a fixed payment or
the return on another stock or equity index. See
Bolster, Chance, and Rich [3996] for details of
equity swaps.
It is well known that, in the plain vanilla
interest rate swap, the swap rate is determined
only through the current term structure of
interest rates (see, e.g., Jarrow and Turnbull
[19961). Using the same arbitrage-kee argu-
ment, it can be shown that the equity swap rate
SUh4MF.R 2001
with conrtant notional principal is also deter-
mined only through the current term struc-
ture of interest rates.
This result is counter-intuitive and has
puzzled practitioners for many years, since
equity prices have no impact on the swap rate.
Chance and k c h [1998] show that, in a deter-
ministic interest rate economy, this conclusion
is true only when the rate is set at the start of
the contract. Thus, the puzzle has been
resolved in part.
Another question then arises as to
whether the equity swap rate, when the rate
is set at the start, is indeed independent of the
equity price process even in the case of vari-
able notional principal. The aim of this article
is to answer this question in a stochastic inter-
est rate economy.
Recall that, in the risk-neutral world, the
instantaneous rate of return of any traded
equity is given by the (non-defaultable) spot
interest rate. Also, an equity swap is a transac-
tion to exchange cash flows equal to the return
on the equity. Hence, the value of the pay-
ments based on the return must be related to
discount bond prices. The equity return also
depends on the volatility of the equity price
process, however, as well as the correlation
with interest rates. This means that the equity
swap rate should be expected to depend on the
equity price process through these parameters.
We confirm this statement in the case of
variable notional principal in a stochastic inter-
est rate economy, thus justifying practitioners’
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
closed-form 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 closed-form
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-
ward-start 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
We consider the stochastic interest rate economy
introduced in Amin and Jarrow [19921. Namely, under the
risk-neutral probability measure P", the time t price of
the risky asset, denoted by S(t),and the instantaneous for-
ward rate at time t for date T, denoted by f(t,T), evolve
according to the stochastic differential equations:
Hence, the SDEs (1) and (2) suffice to construct our
economy.
Later, we consider the Gaussian interest rate econ-
omy in order to obtain closed-form solutions for various
equity swap rates. Although the interest rates become
negative with positive probability, the probability is often
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

20 PRICING EQUITYSWAPS IN A STOC'HASTLC INTEKEST RATE

ECONOMY SUMMER 2001
where 0’= ~f + C Y ~and, where In x denotes the natural 11. VALUATION FRAMEWORK
logarithm of x. Also, it is well known (see, e.g., Heath,
Jarrow and Morton [19921) that The forwzp-d-neutral valuation framework seems
particularly usef;l for the pricing of derivatives in the
stochastic interest rate economy. The forward-neutral
method is parallel to the ordinary risk-neutral fi-ame-
work, so we review the risk-neutral method in order to
highlight the basic ideas that the two methods share. In
a(t. T)dq(t). t5T (4) the following, we assume that the current time is 0.
whe e, in this case, a(t, T) = -$(t, T) with P(t, T) =
J,e-tf Wu)duds, t 2 T. The Risk-Neutral Method
Now, according to Inui and fijima [ 19981, this case
reduces to the extended Vasicek model of Hull and White Let C(t) be the time t price of a European deriva-
[ 19901. Namely, the spot rate process is given by tive maturing at time T written on the risky asset S(t). It
is assumed that the derivative is valued by the arbitrage-
free valuation paradigm.
+a 1
i
d r ( t ) = / € ( t ) [ f ( O .t ) - r ( t ) ] &f(0. t ) + $(t) x We consider a self-financing portfolio that consists
of the risky asset S(t) and the money market account
B(0,t). Let e(t)be the number of units of the risky asset
dt + (t) (5)
held in the portfolio, and let b(t) denote the amount in
where the money market account. Then, the value of the port-
folio is given by

+ J’ b(s)dB(O,s) t
C ( t )= C ( 0 )
0

The significance of the extended Vasicek model is

that the model is consistent with the current term struc-
ture of interest rates. Moreover, the time t price of the dis-
count bond maturing at time T is given by The portfolio is said to replicate the European
derivative if
u(0,T )
z(t. T ) = -x
v(0.t ) C ( T )= x

where X is the payoff of the derivative at maturity T.

Under the arbitrage-fi-ee condition, the current price of
the derivative must be equal to C(0).
t5T (7) Let S*(t) denote the relative price ofS(t) with respect
to the money market account B(0, t):

Note that, since K(t) is a deterministic function of

time, both P(t, T) and $(t) are also deterministic hnctions
of time t, so uncertainty in the bond price v(t,T) is due
to the spot interest rate r(t) only.
Other relative prices are defined similarly. Then,
since B*(O, t) = 1 for all t so that dB*(O, t) = 0, we have

SUMMER
2001 21
THEJOURNAL OF DERIVATIVES
 C*(t)= C*(O) + J" O(s)dS*(s),
0
t5T

Hence, if S*(t) is a martingale under some proba-
bility measure (in fact, it is a martingale under the risk-
neutral measure P"), the relative price process C*(t) is also
a martingale. Denoting the expectations operator under
P* by E*, it follows that
Hence, if S,(t) is a martingale under some proba-
bility measure, PT, say, the forward price process C,(t) is
also a martingale. Denoting the expectations operator
under PT 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 ]

The probability measure PT is called the forward-

This is the basic idea in the risk-neutral valuation
method.
The Forward-Neutral Method
In contrast to the risk-neutral method, the forward-
neutral method considers a self-financing portfolio that
consists of the risky asset S(t) and the discount bond v(t,
T). Let O(t) be the number of units of the risky asset, and
let b(t) denote the number of discount bonds held in the
portfolio. That is, the value of the portfolio is given by
neutral measure, because the forward price process is a
martingale under PT.
Supposing that the risk-neutral measure P* and the
forward-neutral measure PTare both found, we thus have
proved the next result, which is a special case of Geman,
Karoui, and Rochet [1995].
Theorem 2. Let X be the payoff of a European
derivative security maturing at time T. The price of the
security at time t is given by

where El and E: denote the conditional expectations

C ( t )= C(0) + / t b ( s ) d t ! ( s .T )+ operators under the risk-neutral measure P* and the for-
0
ward-neutral measure PT,respectively.
We next seek the forward-neutral measure PT in our
Gaussian economy. First, from (3) and (4), we obtain

Other notation and definitions remain the same.

Let S,(t) be the forward price of S(t):

and
Other forward prices are defined similarly. Then,
since v,(t, T) = 1 for all t, we have

22 PRICING EQUIIT SWAPS IN A STOCHASTIC INTEREST R A T E E<ONOMY SUMMER2001

 dln vT(t, 7) = pv(t,T ,7 ) d t + zr(t) = zl(t)- / a ( s ,T)ds,
0
t
z;(t) = zz(t) (9)

provided that a(<,’T) f a(t, T), which rules out the deter-
ministic interest rate case. Also, under the fonvard-neu-
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

These processes are drifiless, so that they are indeed mar-

tingales under PT.
Now, using Ito’s formula, we obtain fiom (10) and
respectively, where ps’(t, T) = a(t, T)(a(t, T) - OJ and (11) that
p’&, T, Z) = a(t, T)[a(t, T) - a(t, T)]. The forward-neu-
trd measure PT is then defined so that z:(t) and zl(t),
ST(t)= ST(0) x

and

are mutually independent, standard Wiener processes.

Notice that the condition (8) is satisfied if the standard a ( s ,T))dzT(s)} , t < T 5 7 (13)
Wiener processes under PT are chosen as
where we define

SUMMER2001 THEJOURNN 23
OF DERIVATIVES

and
t maturity T, v(t, T), is given by
&(t1 T ,7) = (a(? 7) - a ( s ,T))2ds, t <T 57
Since a(t, T) is deterministic, and since zr(t) and z,’(t)
are normally distributed with mean 0 and variance t
under PT,both the forward price processes S,(t) and vT(t,
T) are lognormally distributed under PT. Also, S,(T) =
S(T) and vT(T,T) = v(T, T). Hence, we have a way to eval-
uate equity swaps.
111. VALUATION OF EQUITY SWAPS
Equity swaps are classified into two categories, one
with constant notional principal, and the other with vari-
able notional principal. In the former case, the notional
principal is a fixed constant through the life of the con-
tract; in the latter case, it changes according to the refer-
enced equity price. We derive the valuation formulas for
equity swaps with constant or variable notional principal
in the Gaussian interest rate economy.
Constant Notional Principal
An equity swap with constant notional principal is
defined as follows: (C 1) A contract starts at time to, to I
0, with an initial notional principal, 1, say; (C2) the pay-
ment dates are ti, 0 < tl < t2 < ..., < tm, with the same
notional principal; and (C3) one party pays the return on
the underlying equity, S(ti)/S(ti- - 1, and the counter-
party pays a fixed payment, R, say, at date t,.
Sin& the profit/loss at time ti on the fixed side is
given by S(ti)/S(ti-l)- 1 - R, the risk-neutral method
reveals that the present value of the equity swap (at time
0) is given by
24 PRICING EQLITY SWAPS IN A STOCHASTIC INTEREST R 4 T E
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)
since the relative price is a martingale under the risk-neu-
tral measure P*. Also, the time t discount bond price with
Using these results, a similar argument to the one
given in Jarrow and Turnbull [19961leads to the formu1a:j
m
i= 1
which coincides with Equation (1) of Chance and Rich
[1998].
If the swap rate is set at the start of the contract, i.e.,
to = 0, then we have
1 - ,U(O.tm)
R=
i= I
since V(0, tm) = 0 by the definition of a swap. Hence, the
equity swap rate with constant notional principal is deter-
mined only through the current term structure of inter-
est rates and is not related to the equity price process.
Notice that we do not assume any volatility struc-
ture to derive this result. In fact, for any interest rate
economy, the same argument as given in Chance and Rich
[1998] can be used to derive the result in (15).
Variable Notional Principal
We consider an equity swap with variable notional
principal defined as follows: (V1) A contract starts at
time to with an initial notional principal, 1, say; (V2) the
payment dates are ti with the notional principal
ECONOMY SUMMER
2001
S(ti- l)/S(to)at date ti; and (V3) one party pays the return
on the underlying equity:

we have

and the counterparty pays a fixed payment RS(ti- ,)/S(to)

at date t,. Note the difference between (C3) and (V3).
The different notional principal drives the different pay-
ments over the two swaps.
Under the risk-neutral pricing paradigm, the pre-
sent value of the equity swap on the fixed side is given by
which agrees with the result obtained by Chance and Fbch
[19981.
In order to evaluate the expected values included in
(17), we now assume the Gaussian interest rate economy.
In the forward-neutral valuation framework, we have
from (12) and (13) that

From (14) and the fact that

IT [a1 + a(t, T)- 2a(t,T ) ]drT(t) +

2 2 2
= E,[s*(t7-1)2l(tz-~,ti)],

it follows that
where zT(t), i = 1, 2, are mutually independent, standard
Wiener processes under the forward-neutral measure P'.
O n the other hand, from Theorem 1, we obtain

to 1. 0 (17)

In particular, if the interest rates are deterministic, where c(t, T, Z) is defined by

then, since

SUMMER
2001 25
THEJOURNAL OF DERIVATIVES

It follows from (17) that the present value of the
equity swap with variable notional principal is given by
(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
and <(t,T, 2) is equal to unity, equation (20) becomes iden-
tical to (18).Also, if CT, = 0, i.e., the equity price process
and the interest rates are uncorrelated, then the term
c(t, T, 2) is a hnction of parameters of interest rates alone.
Finally, we note that various types of equity swaps con-
sidered in Chance and Rich [1998] can also be easily eval-
uated using (20).
If, in particular, the swap rate is set at the start of the
contract, i.e., to = 0, then we have
since V’(0, tm) = 0. The swap rate R in this case does
depend not only on the current term structure of inter-
est rates but also on the stock price process, via o1if o1
f 0, that is,‘-ifthe equity price process is correlated with
the interest rates.
IV. VALUATION OF CAPPED EQUITY SWAPS
A capped equity swap is an equityswap with a con-
stant limit on the equity return. Chancd,and Rich [1998]
discuss the pricing of a capped equity swap with constant
notional principal in the deterministic interest rate econ-
omy but they leave the price of forward-start European
call options unspecified. We derive closed-form solutions
26 PRICINGEQUITY SWAP^ IN 4 S T O ~HASTIC INTEREYT
RATE
Ec ONOMY
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.
Constant Notional Principal
Since the return, S(ti)/S(ti- -1, is capped by K,
the cash flow at date ti on the fixed side is given by
where we denote X 3 K + 1. Note that the first term in
(22) is identical to the cash flow of the equity swap with
constant notional principal, while the second term is that
of the forward-start European call option with maturity
ti, strike price X, and starting date ti-
Let us denote the price of the forward-start Euro-
,, ,
pean call option by c(ti- ti, X), 0 Iti- < ti. From The-
orem 1 we obtain
c(ti-1, ti, X)= v(0,ti) x
Using the forward-neutral method, we have the
result as follows (proof is given in Appendix A).
Theorem 2. In the Gaussian interest rate economy,
the price of the forward-start European call option is
given by
c(t2-1, ti, X) = u ( 0 , ti-l)@(d) -
SUMMER2001
where @(x) is the standard normal distribution function Variable Notional Principal
and where
Finally, we consider a capped equity swap with vari-
able notiona1 pridipal. Using the same notation as above,
the cash flow at time tl on the fured side is given by

with
I.-
+RI]-

It should be noted that the parameter C T ~is involved

through 6,in (24).Hence, the equity price process affects
the price of the forward-start European call option, unless
o1= 0.
Now, since Note that the first term in (27) is the cash flow gen-
erated by the equity swap with variable notional princi-
pal, while the second term is that of the forward-start
European call option multiplied by S(ti - ,)/S(t,).
For 0 5 ti - < tl, let

[ 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 forward-start European call option is
given by6

C’(t&l, ti,X ) = @(d)-

where to I0. If, in particular, the rate is set at the start of
the contract, i.e., to = 0, then the swap rate is determined
by
m

i=l
R= m
where 0%is given in Theorem 2, and where

SUMMER2001 THEJOURNAL OF DERIVATIVES 27


with
In order to explain the difference between Theo-
rems 2 and 3, we put Y - lnS(0) in Appendix B. That
is, we set ti- = 0, so that v(0, ti- = 1 and q(0, ti- 1,
,,
ti) = 0. We then obtain c'(ti- ti, X ) = c(ti- 1, ti, X) in
the two theorems. This means that the difference between
the two cases, constant or variable notional principal,
appears through the hnction ~ ( 0ti,- 1, ti) in Theorem 3.
As is shown in Appendix B, the function q(0, ti - ti) ,,
expresses the covariance between In S(ti- 1) and In S(ti -
1) / S (ti).
Proposition 2. The present value of the capped
equity swap with variable notional principal is given by
b;&IJ. t,, X)= T."(to. t m ) -
m swaps with long maturity.
c ' ( t z - l . t,. X)
1=2
The swap rate when set at the start of the contract
is given by
m at time 0, which is shown in Exhibit 1. The other param-
I
V. NUMERICAL EXAMPLES
Some numerical examples help us investigate the
impact of correlation between interest rates and the equity
price process on equity swap rates. Recall that the swap
rate is independent of the interest rates in the constant
notional principal case, while it depends on o1through
((t, T, 2) in (19) in the variable notional principal case.
We choose the parameters for the interest rates from
Inui and Kijima [1998]; that is, we set K(t) = K = 0.05 for
t 2 0, and y = 0.01. The current forward rate curve is set
to be f(0, t) = a + bt + ct2 where a 0.03, b = 0.005,
and c = -0.0002. Note that
Y (1 - e- " ( T - t ) )
a ( t ,T ) = --
6
Y2
qqt) = - (1 - P t )
2K
Also, we set o2= 0.2, while 0, is used as a parame-
ter. All the swaps considered in the examples pay interest
annually, and the initial price of the risky asset is set to be
S(0) = 1.
Given these parameter values, we first calculate the
term structures of swap rates in the constant and variable
notional principal cases using (16) and (22), respectively.
The results are shown in Exhibits 1 and 2.
In the variable notional principal case, even if the
equity price process and the interest rates are uncorrelated,
i.e., o1= 0, the swap rates are slightly higher than those
in the constant notional principal case. Also, as the value
of o1increases, i.e., the correlation becomes greater, the
swap rates become higher. The dfference in the swap rates
cannot be negligible especially for large t,,, i.e., for equity
Next, we calculate the present values of capped equity
swaps according to Propositions 1 and 3. O f particular
interest are the impacts of the cap rate K, the maturity, and
the value of o1on the present values. E h b i t s 3 and 4 depict
the present values for the constant and variable notional
principal cases. The swap rate R is set to be the swap rate
eters are set to be the same as before.
Note that, as the cap rate increases, the present
value of the capped equity swap increases. The increas-
ing rate decreases gradually, however, so that the present
value approaches zero as the cap rate goes to infinite. The
higher the value of CT,,the lower the value of the equity
swap. The effect of C T ~on the value diminishes as the cap
rate increases or the maturity shortens. Although these
graphs look very similar, the effect of oI on the value in
the variable notional principal case is greater than that in
the constant notional principal case.
E X H I B I T1
Swap Rates for Equity Swaps WO)

notional swap maturity (years)

principal 1 CT~ 1 2 3 4 5 6 7 8 9 10
constant 3.30 3.53 3.75 3.95 4.13 4.30 4.46 4.59 4.72 4.83

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 rates-for the plain vanilla interest-rate swap, and the rates are equal to those in the constant
notional principal case.

Finally, we calculate the swap rates for capped equity
swaps accordmg to (26) and (30). Exhibits 5 and 6 show
the swap rates for the constant and variable notional prin-
cipal cases. As the cap rate or the maturity increases, the
swap rate rises. When the cap rate is too low, the present
value of a capped equity swap is negative on the tixed side,
so that the swap rate becomes negative.
For example, in the case of the constant notional
principal with tm = 5 and o1= 0.1, if the cap rate is lower
than 19.7%,the present value of the capped equity swap is
negative, even for the case that R= 0. It is observed that the
swap rate rises as o1is reduced in the constant notional prin-
cipal case (see Exhibit 5), but such a relation fails in the vari-
able notional principal case when the cap rate is high and
the maturity is long (see Exhibit 6). The dIfZerence between

SUMMER2001 THEJOURNAL OF DERIVATIVES 29

 EXHIBIT3
Present Values of Capped Equity Swaps with Constant Notional Principal-Proposition 1

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

0% 5% 10% 15% 20%

Cap Rate -Swap Rate

The present values are calculated based on Proposition 1. The swap rate R is set to be the swap rate at time 0, which is shown in Exhibit 1. T h e other param-
eters are set to be the same as in Exhibit 2.

EXHIBIT4
Present Values of Capped Equity Swaps with Variable Notional Principal-Proposition 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%

Cap Rate- Swap Rate

77ie present values are calculated based on Proposition 2. 7'he parameters are set to be the same as in Exhibit 3 . Although thefigures look very similar to them
in Exhibit 3, the ejert $0,on the value in the variable notional principal cae is larger tkun that in the constant notional principal case.

30 PRI(:ING EQUITY SWAPS I N .4 STOC:HA>TIC:INTEREST RATE ECONOMY SUMMER moi

E X H I B I T5
Swap Rates for Capped Equity Swaps with Constant Notional Principal-Equation (26)

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 Principal-Equation (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.

SUMMER2001 31
THEJOURNAL OF DERIVATIVES
the two cases comes from c(0, ti - ti) in (30), which
depends on al.

VI. CONCLUDING REMARKS

We have demonstrated valuation of equity swaps

with constant or variable notional principal in a stochas-
tic interest rate economy. Unlike the deterministic inter-
est rate case considered in Chance and Rich [1998], our
pricing formulas include correlation between interest
rates and the equity price process, which justifies the On the other hand, from (5) and (9), we have
practitioners' belief that equity prices affect the value of
an equity swap. The key tool to derive the formulas is the
forward-neutral method.
It is shown that the swap rate for the plain vanilla
equity swap with constant notional principal is deter-
mined only through the term structure of interest rates
in any stochastic interest rate economy, wlde the swap rate O F v ~ t z
with variable notional principal depends on the equity
price process. Dependence of the swap rate on the equity where
price process, the maturity, and the cap rate is examined
through numerical examples, whch reveal that the impact
of stochastic interest rates on equity swaps is considerable.
We assume Gaussian interest rates, so that interest d
rates become negative with positive probability. This may -f(O,
8.5
s) + d(s) + ya(s, t,). s20
be the main limitation of our study. It should be inter-
esting to carry out Monte Carlo simulation experiments
for the pricing of equity swaps in a non-Gaussian inter-
est rate economy.
Another important instrument in equity swaps is the
equity swaption. The valuation of equity swaptions is (A-2)
considered in Chance and k c h [1998] for the deter-
ministic interest rate economy. Although they point out It follows from (A-1) and (A-2) that
that the price of an equity swaption with constant notional
principal is independent of the equity price process, this
property does not hold in our stochastic interest rate set-
ting, and hrther investigation may be necessary to derive
useful results.

A P P E N D I XA
Proof of Theorem 2

First, note that S(tlw1)=Sti(tlT1)v(tl- ,, t,). Hence, using

(7) and (12), we obtain
'.

(A-3)

32 PRICING EQUITY SWAPS I N A STOCHA\TIC INTEREST R A T E ECONOMY SUMMER

1001
 Here we have used the fact that

= 0 (A-4
Similarly, by the change of variables U and s, we obtain
whose proof is gk7en below. Now. (A-3) means that x = In
[S(tJ/S(t,- is normally distributed Lvith mean p, and vari-
ance 01. where

and
It follows that

Theorem 2 now follows.

Proof of t(t,
ti - ti) = 0. For simplicity, let t = 0 and
denote which is equal to - @ ( t i ,)P(t,-
- ,,ti), whence the desired result
from (A-5).

APPENDIX
B
Proof of Theorem 3

where

and

From the change of the order of integrations, we obtain:

where C[u, Z ] denotes the covariance between Y and Z .
Non7, using (7), (12), (A-2), and (A-4), we obtain

SUMMER
2001 33
THEJOURNAL OF DEKIVATIVES
 E: [f(Z - C [ Y ,Z ] ) ]=

where d' and 0,are defined as in the theorems, completing the

proof.
Lemma. Suppose that (X, Y) is jointly normally dis-
tributed. Then

Since (l3-1) implies that Y is normally distributed with mean

& and variance CT;, where for any f(x) for whch the expectation exists, where C [ x , Y]
denotes the covariance between X and Y.
ProofofLernma. Let <(x, y) be the joint density of (X,
Y) anddefine

Then:
and

Denoting the moment-generating function of (X, Y) by

we obtain ~ ( s t), = Et[esXcrY],
we obtain

Since SX- Y is normally distributed, it follows that

O n the other hand, fiom (A-3) and (B-l), we have

q(s. -1) = exp

= [(O.
1
1
- V [ Y ] - SC[X.Y ]
2

t+1. ti;l - q(0,t t - l . t J

= -V(O, tt-I. t*,l (B-2)

G2 [ X ] }
Hence, (A-3) and (€3-2) together imply that Z - C p , Z ]
+
is normally distributed with mean 1.1, ~ ( 0tl,- tJ and vari-
ance 0;.It follows that

34 PRICING EQUITY SWAP5 IN A sTO('t[A5TlC' INTER€$T RATEECONOMY SUMMER

2001
 Recall that the moment-generating function determines
the dstribution uniquely. if it exists. Hence, we conclude that
5x(x)/E[e-y] is a density function of the random variable (X -
C[X, Y]). It follows that
completing the proof.
ENDNOTES
‘Chanceand k c h [1998] do not provide pricing formulas
for the forward-start European options.
’In order to guarantee the existence of solutions in the
SDE’s (1) and (2) for the general case, we need to impose some
con&tions on the drift and volathties. In our Gaussian case,
however, there always exists a unique solution. Also, since a
rise in the forward rate reduces today’s stock price in practice,
we expect a negative correlation between the stock retum and
the forward rate. Hence, it is plausible to assume that either o1
in (1) or y in (2) is negative. In either case, the drift term in (2)
is positive, which converges to zero as t + T.
“The analysis is vahd even when the Wiener processes
have a deterministic correlation, i.e., dz,(t)dz,(t)
,- = p(t)dt with
p(t) a deterministic function of time t.
4 0 ~results
r can be extended to the case that o1and y are
deterministic functions of time t.
‘A detailed derivation is available from the authors upon
request.
‘Although it is natural to expect that the right-hand side
of (29) is multiplied by v(0, ti - 1), thls is unnecessary because
the cash flow at ti reflects the gross rate ofinterest, S(ti- l)/S(tJ,
up to time ti-l in the variable notional principal case.
SUMMER 2001
REFERENCES
Amin, K.I., and R.A. Jarrow. “Pricing Options on Risky
Assets in a S t o c k t i c Interest Rate Economy.” Mathematical
Finanre, 2 (1992). pp. 217-238.
Bolster, P., D.M. Chance. and D. Rich. “Executive €quit).
Swaps and Corporate Insider Holding.” Financial Management,
25 (Summer 1996), pp. 14-23.
Chance, D.M., and D. Rich. “The Pricing ofEquity Swaps
and Swaptions.” TlwJoumal of Den’variiles, 5 (Summer 1998),
pp. 19-31.
Geman, H., N.E. Karoui. and J.C. Rochet. “Change of
Numeraire, Changes of Probability Measure and Option Pric-
ing.”]ounzal $Applied Prol>ability,32 (1995), pp. 443-458.
Heath, D., R.A. Jarrow, and A. Morton. “Bond Pricing and
the Term Structure of Interest Rates: A New Methodology
for Contingent Claims Valuation.” Econometrica, 60 (1 992),
pp. 77-105.
Hull, J., and A. m t e . “Pricing Interest-Rate-Derivative Secu-
rities.” Review of Financial Studies, 3 (1990), pp. 573-592.
Inui, K., and M. Kijima. “A Markovian Framework in Multi-
Factor Heath-Jarrow-Morton Models.”Joumal ofFinancia1 and
Quantitative Analysis, 33 (1998), pp. 423-440.
Jarrow, R.A., and S . Tumbull. Derivative Securities. Cincinnati:
South-Westem Publishing, 1996.
35
THFJOURNAL O F DERIVATIVES