Definition of Equity Swaps
Equity swaps are a type of derivative contract between two parties who have agreed to swap a set of cash flow at set dates in the future. The two cash flows are commonly referred to as ‘legs’, with one leg being ‘floating leg’ whereas the other leg is referred to as the ‘equity leg’.
Explanation
An equity swap is a type of financial derivative contract where two counterparties have agreed to exchange the future cash flow at set dates. These cash flows are commonly called legs of the swap. One among these legs is based on floating rate and, therefore, referred to as ‘floating leg’. While the other leg is based on the performance of the share, stock, or the stock market index, etc. So, the other leg of the cash flow is referred to as the ‘equity leg’.
Features of Equity Swaps
- An equity swap is quite identical to an interest rate swap, but unlike an interest rate swap in which one leg is being the fixed side, equity swaps are based on the return of the equity index.
- Equity swaps are usually exchanged between large financial firms.
- It provides exposure to the equity index or the stock exchange without having possession of 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 that has 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 having to purchase shares, mutual fund or exchange-traded fund (ETF), etc. These equity swaps are usually exchanged between large financial firms.
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:
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- Fixed interest rate swap: In this type of contract, you pay on the basis of fixed interest rate and receive the returns on equity.
- Floating interest rate swap: In such type of equity swap contract, you pay on the basis of 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 some another equity.
Applications of Equity Swaps
Generally, equity swaps are entered to avoid transaction costs, limitation on leverage, or to avoid local dividend taxes. But besides these benefits, equity swaps also give benefits such as:
- Usually, an investor loses possession of shares once the shares are sold, but by using the equity swap, an investor can pass out the negative returns on the equity position without having to lose the voting right or the possession of the share.
- Equity swap enables investors to receive interest from such shares which are not available for them due to legal issues.
Equity Swap Valuation
The net present value of future cash flows being netted off against each other is the value of the swap. Originally the values of these two cash flows are equal to zero, but once they are traded, they can either get positive or negative, which is directly dependent upon the underlying variables.
In the equity swaps, the first leg, which is known as the floating leg, is being valued by deteriorating it into a forwarding rate agreement; after that, to value them, the implied forward rates are being used in the zero-coupon curve. The other leg, which is called the ‘equity leg’, is based on stock market stock’s performance, stock market index. Techniques of option pricing price the equity leg. Once both of these 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 having to purchase 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 enjoys the benefit of no transaction costs by entering into equity swaps.
- Exposure to a wider range of securities: An equity swap enables investors’ exposure towards the wider range of securities which are not easily available for them.
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 which makes them inefficient to provide 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 equity index with other cash flow. 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 also enables the investor to invest in a wider range of securities.
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