An equity swap is a financial derivative contract where a set of future cash flows are agreed to be exchanged between two counterparties at set dates in the future. The two cash flows are usually referred to as "legs" of the swap; one of these "legs" is usually pegged to a floating rate such as LIBOR. This leg is also commonly referred to as the "floating leg". The other leg of the swap is based on the performance of either a share of stock or a stock market index. This leg is commonly referred to as the "equity leg". Most equity swaps involve a floating leg vs. an equity leg, although some exist with two equity legs. An equity swap involves a notional principal, a specified duration and predetermined payment intervals. The term "tenor" may refer either to the duration or the coupon frequency. Equity swaps are typically traded by delta one trading desks.
Examples
Parties may agree to make periodic payments or a single payment at the maturity of the swap. Take a simple index swap where Party A swaps £5,000,000 at LIBOR + 0.03% against £5,000,000. In this case Party A will pay a floating interest rate on the £5,000,000 notional and would receive from Party B any percentage increase in the FTSE equity index applied to the £5,000,000 notional. In this example, assuming a LIBOR rate of 5.97% p.a. and a swap tenor of precisely 180 days, the floating leg payer/equity receiver would owe *£5,000,000*180/360 = £150,000 to the equity payer/floating leg receiver. At the same date if the FTSE had appreciated by 10% from its level at trade commencement, Party B would owe 10%*£5,000,000 = £500,000 to Party A. If, on the other hand, the FTSE at the six-month mark had fallen by 10% from its level at trade commencement, Party A would owe an additional 10%*£5,000,000 = £500,000 to Party B, since the flow is negative. For mitigating credit exposure, the trade can be reset, or "marked-to-market" during its life. In that case, appreciation or depreciation since the last reset is paid and the notional is increased by any payment to the floating leg payer or decreased by any payment from the floating leg payer. Equity swaps have many applications. For example, a portfolio manager with XYZ Fund can swap the fund's returns for the returns of the S&P 500 They most often occur when a manager of a fixed income portfolio wants the portfolio to have exposure to the equity markets either as a hedge or a position. The portfolio manager would enter into a swap in which he would receive the return of the S&P 500 and pay the counterparty a fixed rate generated from his portfolio. The payment the manager receives will be equal to the amount he is receiving in fixed-income payments, so the manager's net exposure is solely to the S&P 500. These types of swaps are usually inexpensive and require little in terms of administration.
Applications
Typically equity swaps are entered into in order to avoid transaction costs, to avoid locally based dividend taxes, limitations on leverage or to get around rules governing the particular type of investment that an institution can hold. Equity swaps also provide the following benefits over plain vanilla equity investing:
An investor in a physical holding of shares loses possession on the shares once he sells his position. However, using an equity swap the investor can pass on the negative returns on equity position without losing the possession of the shares and hence voting rights.
It allows an investor to receive the return on a security which is listed in such a market where he cannot invest due to legal issues.
Equity swaps, if effectively used, can make investment barriers vanish and help an investor create leverage similar to those seen in derivative products. However a clearing house is needed to settle the contract in a neutral location to offset counterparty risk. Investment banks that offer this product usually take a riskless position by hedging the client's position with the underlying asset. For example, the client may trade a swap – say Vodafone. The bank credits the client with 1,000 Vodafone at GBP1.45. The bank pays the return on this investment to the client, but also buys the stock in the same quantity for its own trading book. Any equity-leg return paid to or due from the client is offset against realised profit or loss on its own investment in the underlying asset. The bank makes its money through commissions, interest spreads and dividend rake-off. It may also use the hedge position stock as part of a funding transaction such as stock lending, repo or as collateral for a loan.
