Structured entity that enters into a total return swap
A structured entity acquires a portfolio of equity securities from the market, issues fixed rate notes to investors and hedges the mismatch in cash flows between the equity securities and the notes through entering into a total return swap with a bank. The choice of equity securities that make up the portfolio is pre-agreed by the bank and the note investors, however, the bank also has substitution rights over the equity securities held by the structured entity within certain parameters. The terms of this swap are that the structured entity pays the bank any increase in value of the securities and any dividends received from them, while the bank pays the structured entity any decline in the value of the securities and interest at a fixed rate.
The structured entity was designed to give equity risk to the bank while the note holders earn a fixed rate of interest. The bank”s substitution rights over the equity securities is probably the relevant activity, because it may significantly affect the structured entity”s returns; therefore, the bank has power. The bank also has an exposure to variable returns since it absorbs the equity risk. Since it has the ability to use its power to affect its returns from the total return swap, all three criteria for control are met and the bank would consolidate the structured entity.