Updated July 14, 2023
Definition of Equity Swaps
Equity swaps are a type of derivative contract between two parties who have agreed to swap a set of cash flows at set dates in the future. The two cash flows commonly refer to as ‘legs’, with one leg being the ‘floating leg’ and the other being the ‘equity leg’.
Explanation
An equity swap is a financial derivative contract with two counterparties agreeing to exchange the future cash flow at set dates. These cash flows are commonly called the legs of the swap. One among these legs is based on a floating rate and, therefore, referred to as the ‘floating leg’. In contrast, the other leg is based on the performance of the share, stock, or stock market index. So, the other leg of the cash flow is called the ‘equity leg’.
Features of Equity Swaps
- An equity swap is identical to an interest rate swap, but unlike an interest rate swap in which one leg is on the fixed side, equity swaps are based on the return of the equity index.
- It usually exchanges between large financial firms.
- It exposes the equity index or the stock exchange without possessing that stock.
- Equity swaps hedge equity swaps exposure risk.
- There are no transaction costs in equity swaps.
How Does It Work?
An equity swap is quite similar to an interest rate swap. However, unlike an interest rate swap with only one fixed side leg, an equity swap has two legs of cash flow. In an equity swap, one of the parties will pay the floating leg, and in the return of which, they will get returns on an index of the stock as agreed upon. It enables the parties to earn returns of an index or equity security without purchasing shares, mutual funds, exchange-traded funds (ETF), etc. Large financial firms typically exchange these equity swaps among themselves.
Examples of Equity Swaps
Suppose an asset manager of a fund wants to track the performance of the ‘S&P 500’ index. So instead of purchasing various securities that track S&P 500, the manager entered into an equity swap contract by swapping $30 million with an investment bank for one year based on ‘LIBOR plus two basis points.
In that one year, if the S&P 500 index falls, then the asset manager of the fund will have to pay the investment bank $30 million multiplied by the percentage the S&P 500 fell. Similarly, if the S&P 500 shows growth in that year, the investment bank has to pay the fund manager of the fund with the difference amount.
Types of Equity Swaps
There are three types of equity swap contracts as below:
- Fixed interest rate swap: In this type of contract, you pay based on a fixed interest rate and receive the returns on equity.
- Floating interest rate swap: In such type of equity swap contract, you pay based on the floating interest rate and receive the returns on equity.
- Equity vs equity: In such equity swap contracts, you pay returns on one particular equity and receive returns on another.
Applications of Equity Swaps
Generally, equity swaps enter to avoid transaction costs, limitation on leverage, or avoid local dividend taxes. But besides these benefits also give benefits such as:
- Usually, an investor loses possession of shares once the shares are sold. Still, using the equity swap, an investor can pass out the negative returns on the equity position without losing the voting right or the possession of the share.
- Equity swap enables investors to receive interest from unavailable shares due to legal issues.
Equity Swap Valuation
The net present value of future cash flows being netted against each other is the value of the swap. Originally the values of these two cash flows are equal to zero, but once they trade, they can either get positive or negative, directly dependent upon the underlying variables.
In equity swaps, the first leg, known as the floating leg, is valued by deteriorating it into a forwarding rate agreement; after that, the implied forward rates use in the zero-coupon curve to value them. The other leg, called the ‘equity leg’, is based on the stock market stock’s performance, the stock market index. Techniques of option pricing price the equity leg. Once both legs are valued, the value of the equity swap can easily be computed by netting off both.
Advantages
Some of the advantages are given below:
- Exposure to the stock exchange: It provides exposure to the equity index or the stock exchange without purchasing the stock.
- Hedge equity risk exposure: Equity swaps are useful to hedge equity swaps exposure as the investor can use them to forgo short-term negative returns.
- No transaction costs: An investor benefits from no transaction costs by entering into equity swaps.
- Exposure to a wider range of securities: An equity swap enables investors’ exposure to a wider range of uneasily available securities.
Disadvantages
Some of the disadvantages are given below:
- Unregulated: Unlike other derivative instruments that the government is regulating, equity swaps usually remain unregulated.
- Expiration dates: Equity swaps have expiration or termination dates, making them inefficient in providing open-ended exposure.
- There is always a possibility of risk in the equity swap for an investor if there is a default in payment by the counterparty.
Conclusion
It is a derivative contract between two parties who have agreed to exchange returns on the equity index with other cash flows. An equity swap helps give the investor exposure to the stock or stock index without having to purchase the stock. These equity swaps are helpful to hedge equity risk and enable the investor to invest in a wider range of securities.
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This is a guide to Equity Swaps. Here we also discuss the definition and how equity swaps work. Along with advantages and disadvantages. You may also have a look at the following articles to learn more –
