An equity swap is a swap where a set of future cash flows are exchanged between two counterparties. The two cash flows are usually referred to as "legs". One of these cash flow streams can be pegged to floating rate of interest or pay a fixed rate (named "equity leg"). The other will be based on the performance of a share of
stockor stock market index(named "floating leg").
Like any other basic swap, the basic equity swap involves a notional principal, a specified tenor and prespecified payment intervals.
Parties may agree to make periodic payments or a single payment at the maturity of the swap ("bullet" swap), the simplest case.
Take a simple index swap where Party A swaps £5,000,000 at
LIBOR+ 0.03% (also called LIBOR+ 3 basis points) against £5,000,000 ( FTSEto the £5,000,000 notional). In this case Party A will pay (to Party B) a floating interest rate (LIBOR +0.03%) 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 (Party A) would owe (5.97%+0.03%)*£5,000,000*180/360 = £150,000 to the equity payer/floating leg receiver (Party B).
At the same date (after 180 days) 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.
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 payer or decreased by any payment from the floating leg payer.
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 riskless 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.
Contract for difference
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