a. Tip is to iceberg
b. Tail is to dog
c. Horn is to rhinoceros
d. All of the above The answer is "d," all of the above. The fixed income, currency and physical commodity markets are dominated not by the outright buying and selling of goods, which both ties up and risks a lot of capital, but by swap transactions. Swaps come in various forms. The one that stands ready to turn the world of equities on its ear is the total return swap. At its most basic level, any swap is simply an exchange of cash flows and risk profiles. Swap participants don't exchange full payment. Instead, payments are made on periodic settlement dates, and default only risks the amount of the payments, not the much larger amount of the underlying notional principal. The key words are "fixed" and "floating." A payment is fixed if its price is known and remains unchanged over the life of the trade. All futures contracts settle into a fixed price over the delivery period, and all stock prices are fixed at the moment the trade is executed.
Let's Go Do the SwapWith the advent of single-stock futures, we should expect the equity swap market to grow and take its rightful place in the multitrillion-dollar swap world. Why? Futures and swaps have a symbiotic relationship. The fixed leg of a swap is frequently set as the present value of the futures forward curve for a given market. Swap traders use strips of futures to either fix their floating position or to float their fixed position. This is why the eurodollar market can trade close to 1 million contracts a day with significant activity in the back months without interest rates changing much at all. By contrast, the federal funds contract, which is employed for the standard hedging function of locking in a borrowing or lending rate for the following month and for speculating on the Federal Reserve's next move, has a steady but unspectacular volume in the tens of thousands each day.
Total ReturnStocks can provide a return to investors in one of two ways: capital gains when the asset is sold, or an ongoing stream of dividends. The tax code creates a powerful incentive for firms to minimize dividend payouts. The total return stream is shifted toward capital appreciation, and that lengthens the effective duration of a stock in the same manner that lower coupon yields increase the effective duration of a bond. The total return for a zero-dividend stock is easy to calculate -- it's simply the price appreciation over the holding period. The calculation of total return for a dividend-paying stock involves making assumptions about reinvestment costs, including both commissions and bid/ask spreads, whether the dividend is received in cash or reinvested in the stock, and what the effective tax rate is for the dividend. Lost in the euphoria most investors feel while holding an appreciating stock is the ugly reality that their risk is increasing as well: Unless you sell some of that stock and pay the appropriate capital gains tax, you are playing a poker game with your entire stake at risk in each hand.