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I've thought about investing in UPRO, the ProShares UltraPro S&P500 3x leveraged ETF. But, of course, I don't want to invest in it until I have a good understanding of it, including its historical returns, the math behind its leverage, and the assets that it holds.

If I look at the list of daily holdings, I find that by far, the fund's largest holdings by "exposure value" are

  • S&P 500 INDEX SWAP CREDIT SUISSE INTERNATIONAL,
  • S&P 500 INDEX SWAP SOCIETE GENERALE,
  • S&P 500 INDEX SWAP UBS AG,

and so on and so forth. Of course, these swaps don't have a ticker symbol or anything, and if I do a Google search for "S&P 500 index swap", all that comes up is lists of ProShares holdings.

The prospectus for UPRO does contain a little more information:

Swap Agreements — Contracts entered into primarily with major global financial institutions for a specified period ranging from a day to more than one year. In a standard “swap” transaction, two parties agree to exchange the return (or differentials in rates of return) earned or realized on particular predetermined investments or instruments. The gross return to be exchanged or “swapped” between the parties is calculated with respect to a “notional amount,” e.g., the return on or change in value of a particular dollar amount invested in a “basket” of securities or an ETF representing a particular index.

So this makes it sound like an S&P 500 index swap is similar to a stock future. Perhaps UPRO has agreed with these financial institutions that at some future point in time, UPRO will pay the institution $300,000,000 and the institution will pay UPRO $100,000 times value of the S&P 500 index. Something like that.

Is there any way to find out what the details of these index swaps actually are?

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In short, there is no way to find out exactly the language of these contracts, but they're total return swaps. Although, in this particular case they may be a little non-standard given the 3x leverage.

Possible high-level structure of the total return swap:

  • UPRO agrees to swap some multiple (typically 1x but in this case it could be 3x) of S&P 500 return with the bank, on some notional amount.
  • UPRO pays some implied financing rate on the notional amount.
  • UPRO posts some initial margin amount to the bank, and the parties exchange daily variation margin plus maybe some adjustment to the initial margin amount.
  • There might be language in the contract for when the deal can be broken under extreme market conditions etc. Due to the leverage being employed here this language may(should) be different than a typical 1x total return swap.

To hedge their risk the bank could then buy futures (and trade dividend swaps because futures don't include divs) or they could find someone that wants to be short the market and write swaps in the other direction, or other things. The financing rates they include on their swaps will be such that they take something out of the middle and make money by essentially acting as a broker.

From this point I'd focus more on the other areas you mentioned: there's been a lot written over the years online generally, and here specifically, about leveraged ETFs, how they rebalance, the math involved etc.

Checkout @BobBaerker's answer to a related question here: Do the rebalancing costs of leveraged ETFs really outweigh the leverage?

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Perhaps UPRO has agreed with these financial institutions that at some future point in time, UPRO will pay the institution $300,000,000 and the institution will pay UPRO $100,000 times value of the S&P 500 index.

It's similar, but the cash flows will be more periodic, even daily. In a swap, one side pays a fixed amount while the other side pays a variable ("floating") amount. In these cases, the other side is paying amounts based on the returns (not level) of the S&P 500.

Since this is a 3X levered fund, it's likely that these swaps pay some amount scaled by 3 times the periodic return of the S&P 500. But it works both ways - so if the index earns less than the rate set in the swap, then the fund will have to pay the other side more money than it gets.

Is there any way to find out what the details of these index swaps actually are?

Probably not - these are over the counter contracts, so if they do not disclose that in their filings, there's no way to know the specific details.

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  • And can you explain why banks would enter into this agreement on something like the S&P 500 which generally goes up year after year? Wouldn't agreeing to pay 3x the return of S&P just guarantee that the bank loses money year over year? Feb 3 '21 at 18:53
  • Not necessarily - a swap is designed to break even given current market expectations. So if the expected return of the S&P is 5% over a period, the swap would be designed so that the bank pays 15% in exchange for 3X the S&P return. If the S&P makes more than that, the bank makes money since it receives more than its fixed payment, and vice versa. The key is that the swap has 3X exposure to the inced (meaning if the index makes 1% over expected returns, the swap pays 3% more).
    – D Stanley
    Feb 3 '21 at 19:21
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Basically, it works as follows. Let’s say you want to have a 3x return of a particular security. If you buy security ABC at $90 and goes up $10 in value your return is 10%. To have 3x the return of ABC or 30% instead of 10% you will need to have to buy such security at a 1/3 of its price or $30, so if the underlying or original ABC goes up by $9 you will be earning 30% because you paid only $30 for ABC. To accomplish this, you contact a major bank or financial institution who in turn will buy the security for $90 for you. You will need to pledge $30 as collateral and meet any margin call or pledge additional cash or marginable securities in case stock ABC falls below $30, otherwise the bank will close the position to make up for any margin deficit. In return for this service, you will pay the bank interests over the differential of the $70 the bank is lending to you to accomplish the 3x return, whether it goes up or down interests will always be charged. So if ABC goes up by $9 your return is 3x or 30% and your initial investment is now $39 minus the interest charged for the $70 lent. If ABC goes down $9 your return will be -3x or -30% so your initial investment of $30 is down to $21. For the bank its initial investment on ABC of $90 goes down to $81 or 10%, the bank will now charge you interest on $79 instead of $70 and still have $21 of your money to cover for $9 drop in value of ABC. If the price of ABC falls by $15 from $90 to $75 the game is over in the absence of pledging additional cash or marginable securities. The drop of $15 will represent 50% of your $30 investment. Since the bank bought ABC at $90 and now is down to $75 and the value of your investment is down to $15 the bank will close its ABS position and take your $15 left to offset for the loss (most likely at a lesser loss to also offset the interest for the swap service). Obviously, the terms and conditions of the margin agreement will call for initial margin deposit and margin maintenance limits but for illustrative purposes and simplicity how this example explains how 3x swaps work. As for UPRO and other 3x leverage ETFs, they will need to rebalance its holdings and securities to keep the 3x returns in line with its objective. When the market goes up is easier to rebalance as they carry a surplus but when markets fall they will starting using such surplus until it is depleted and close the ETF unless they reach an agreement with its lender and do reverse splits and adjust the capital needed to meet the 3x objective.

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