Equity swap

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An equity swap is a swap where a set of future cash flows are exchanged between two counterparties. One of these cash flow streams will typically be based on a reference interest rate. The other will be based on the performance of a share of stock or stock market index. The two cash flows are usually referred to as "legs".

[edit] Examples

The simplest case would be a "bullet" swap in which all payments are made at maturity.

Take a simple index swap where a party swaps £5,000,000 at LIBOR + 0.03% (also called LIBOR + 3 basis points) against £5,000,000 FTSE equivalent for 6 months. At trade's end, that party (the floating rate payor/equity receiver) would owe to the other the LIBOR-based floating amount plus any percentage decline in the FTSE applied to the £5,000,000 notional. That party would receive from the other party any percentage increase in the FTSE applied to the £5,000,000 notional.

Assuming a LIBOR rate of 5.97% p.a. and a swap tenor of precisely 180 days, the floating leg payor/equity receiver would owe £150,000 to the equity payor/floating leg receiver calculated as (5.97%+0.03%)*£5,000,000*180/360.

If the FTSE at the six-month mark had risen by 10% from its level at trade commencement, the equity payor/floating leg receiver would owe £500,000 to the floating leg payor/equity receiver calculated as 10%*£5,000,000. If, on the other hand, the FTSE at the six-month mark had fallen by 10% from its level at trade commencement, the equity receiver/floating leg payor would owe £500,000 to the floating leg receiver/equity payor calculated as 10%*£5,000,000.

As a mitigant to 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 rate payor or decreased by any payment from the floating leg payor.

[edit] Applications

Typically Equity Swaps are entered into in order to avoid transaction costs (including Tax), to avoid locally based dividend taxes, limitations on leverage (notably the US margin regime) or to get around rules governing the particular type of investment that an institution can hold.

Investment banks that offer this product usually take a risk-neutral position by hedging the client's position with the underlying asset. For example, the client may trade a UK cash equity swap - say Vodafone. Bank credits the client with 1000 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 (1000 Vodafone at GBP1.45). 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 (paying the client less of the dividend than it receives itself). It may also use the hedge position stock (1000 Vodafone in the previous example) as part of a funding transaction such as stock lending, repo or as collateral for a loan.