Funding Legs and Upfront Costs in Autocallable Equity Swaps

# What is the purpose of a floating interest rate leg on an autocallable equity swap transaction?


# What is the purpose of a floating interest rate leg on an autocallable equity swap transaction?












I understand that the purpose of the equity leg is to hedge the issuers exposure under the note but I don't understand why the buyer of an autocallable equity swap pays a fixed fee at the beginning of the trade and also floating interest payments. What do they represent exactly?

## Answer by AKdemy (score 6, accepted)

https://quant.stackexchange.com/a/78211

The swap part is very similar to a vanilla interest rate swap, where typically fixed payments are swapped for float payments between two counterparties. With an IRS, the fixed leg is priced such that there is no upfront payment. If you had only one side of the swap (say receive fixed), you would have to pay a hefty upfront fee for the structure.

With an autocallable, there is an upfront payment. However, that payment depends heavily on the exact contract specifications.

An autocallable itself can have many variations. The swap falls into the "mode" selection which usually has these choices

- option: no principal protection

- note: principal protection

- swap: you add a funding leg (can be fixed or float, usually float).

there exists also the choice for coupon

- none

- standard

- memory

- ko

The early redemption (autocall) has barriers and call amounts that usually increase with each period.

The final redemption can be based on several performance types (of basket)

- worst

- best

- rainbow

- weighted

The underlying-dependent `payoff` is usually computed (in a note) as

```
 = Max[Notional + Participation *
 Min(0,Performance -1)), Floor]
```

where participation is the enhancement applied to the return of the underlying security (frequently 100%).

The final barrier can have various types (usually down and in) and also be at expiry, discrete, or continuous.

These are just a few customizations that are available. They all have something in common though:

- The more you benefit (e.g. principal protection), the more you pay upfront.

- The less you benefit (e.g. paying a funding leg), the less you pay upfront for the structured product.

TL;DR

These products are frequently sold to retail as well and the structurer will try to come up with a product that "sounds" good to the potential buyers. Paying a funding leg over time makes the initial cost lower and often makes the structure look more attractive (cheaper to enter).

In terms of pricing, you just add it all together and run a Monte Carlo Simulation to determine the expected cashflows and hence fair value of the product. The more inflows the autocall buyer can expect, the more expensive. The more outflows, the less expensive.

That said, the model used in your Monte Carlo simulation needs to be able to capture all these details properly, otherwise you will misprice the product. That reminds me of an excellent tweet I stumbled upon some time ago:

Many people tend to think if a tool gives a price it works (here Monte Carlo with Local Vol for example). However, that is classic GIGO.