Equities · E6 · 8 min
Delta one: swaps, CFDs and ETFs
Work out what a share swap pays, say why funds use swaps instead of buying shares, and explain what keeps an ETF’s price close to its holdings.
In the news: “Bond ETF trades at a wide discount to its holdings”: what normally closes that gap, and when it can’t.
The essentials
- Total return swaps and CFDs
- A pays one side a share’s price change plus dividends in return for interest on the notional: the result of owning the shares without buying them. A is the same deal in a standard form.
- The two legs
- The performance leg pays the price change plus dividends; the financing leg charges an overnight rate, such as in sterling, plus a spread. Paying 5% a year on £10m for 73 days costs £100,000.
- Why use a swap
- A swap needs only a deposit, which gives . It lets a fund go short without borrowing stock and reach hard-to-trade markets, and in the UK it avoids the 0.5% on buying shares.
- Delta one
- Products that move one for one with the shares underneath, such as swaps, CFDs and futures. A desk hedges what it gives clients, so it earns from financing and trading, not from direction.
- ETFs and NAV
- An is a fund whose units trade on an exchange all day; is its holdings’ value per unit. create or redeem units, keeping the price within their costs of NAV.
Net payment on a total return swap
Net = N × R − N × (rate + spread) × days ÷ 365
- N
- the amount the swap is on (the notional)
- R
- the shares’ return over the period: price change plus dividends
- rate
- the overnight interest rate, such as SONIA
- spread
- the bank’s extra charge for financing
How it works
1. A share’s return without owning it
You and a bank make a deal on £1m of shares. The bank pays you whatever those shares gain, plus their dividends. You pay the bank interest on £1m. You get the result of owning the shares without buying them. That deal is a .
2. The two legs
One side receives the performance leg: the price change plus dividends. It pays the financing leg: an overnight interest rate plus a spread, for the days the swap runs. In sterling the rate is usually , the Bank of England’s measure of what banks pay to borrow overnight. Financing = notional × (rate + spread) × days ÷ 365.
3. Why use a swap
A fund only needs to post a deposit, not the full value, so it can take a bigger position: that is . It can bet on a fall without borrowing shares itself, because the bank handles that, and reach markets that are hard to trade directly. And in the UK, buying shares costs 0.5% on most purchases, while a swap pays none.
4. CFDs
A , or contract for difference, gives the same deal in a standard, ready-made form: you get the price change and dividends and pay interest, posting only a deposit. CFDs are widely used in the UK by hedge funds and individual traders. With a swap or a CFD, you depend on the bank or broker on the other side to pay what it owes.
5. What delta one means
Swaps, CFDs and futures all move one for one with the shares underneath. In options language their sensitivity, or , is one, so this corner of the market is called . A delta one desk gives clients this exposure and holds the shares to cover it, so it earns from financing and trading, not from guessing direction.
6. ETFs: a fund that trades like a share
An is a fund, often holding every share in an index, whose units trade on the stock exchange all day. The value of its holdings per unit is its , net asset value. The price can drift a little from NAV: at £101 with a NAV of £100, it is at a 1% premium.
7. Creation and redemption
Big trading firms called close the gap. If the ETF trades above NAV, they buy the shares it holds, swap them with the fund for new units and sell those units. If it trades below, they buy units and swap them back for the shares. So the gap stays within the cost of doing this.
8. When the holdings are hard to trade
For bonds the gap can be wider, because the bonds themselves trade less easily than the ETF. In March 2020 corporate bond ETFs traded well below NAV. The NAVs used estimated bond prices that lagged the market, while the ETFs showed where bonds could actually be sold.
Worked example
A hedge fund receives the total return on £20m of UK shares for 91 days and pays SONIA + 0.5%. Suppose SONIA averages 4.0% and the shares return 3.0% including dividends.
- Performance leg: £20m × 3.0% = £600,000 to the fund.
- Financing rate: 4.0% + 0.5% = 4.5% a year.
- Financing leg: £20m × 4.5% × 91 ÷ 365 = £224,384 from the fund.
- Net: £600,000 − £224,384 = £375,616 to the fund.
The fund receives about £375,600: the shares’ return without buying them or paying stamp duty.
Check yourself
8 quick questions on the explanation above.
Practice
New numbers every set. Misses and guesses go into your review deck.
In the interview
Answer out loud in under a minute, then compare.
Why would a hedge fund use a total return swap instead of buying the shares?
How does an ETF stay close to its NAV?
Remember
TRS net = N × return − N × (rate + spread) × t
Delta one products copy owning the shares; the money is made on financing and trading, not on direction.
Sources
- GOV.UK (HM Revenue and Customs) — Tax when you buy shares: buying shares electronically
- Bank for International Settlements — BIS Bulletin No 6: The recent distress in corporate bond markets: cues from ETFs
Definitions and maths are standard textbook material; dated facts link to the sources above. Worked numbers are illustrative.