Equity Swaps

Equity Swaps Definition

Equity Swaps is defined as a derivative contract between two parties that involve the exchange of future cash flows, with one cash stream (leg), determined on the basis of equity-based cash flow such as return on an equity index, while the other cash stream (leg) depends on fixed-income cash flow like LIBOR, EuriborEuriborThe Euro Interbank Offer Rate (Euribor) is the interest rate at which European Union banks lend funds to each other. It is a daily changing benchmark and reference interest rate that includes terms ranging from a week to a year.read more, etc. As with other swaps in financeSwaps In FinanceSwaps in finance involve a contract between two or more parties that involves exchanging cash flows based on a predetermined notional principal amount, including interest rate swaps, the exchange of floating rate interest with a fixed rate of interest.read more, variables of an equity swap are notional principal, the frequency at which cash flows will be exchanged, and the duration/ tenor of the swap.

Equity-Swaps

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Example of How Equity Swaps Work?

Consider two parties – Party A and Party B. The two parties enter into an equity swap. Party A agrees to pay Party B (LIBOR + 1%) on USD 1 million notional principal, and in exchange, Party B will pay Party A returns on the S&P index on USD 1 million notional principal. The cash flows will be exchanged every 180 days.

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In the above example, if the returns of stocks were negative, say -2% for the reference period, then Party B would receive USD 30,000 from Party A (LIBOR + 1% on notional) and in addition would receive 2% * USD 1,000,000 = USD 20,000 for the negative equity returns. This would make a total payment of USD 50,000 from Party A to Party B after 180 days from the start of an equity swap contract.

Advantages of Equity Swaps

The following are advantages of equity swaps:

  • Synthetic Exposure to Stock or Equity Index – Equity swaps can be used to gain exposure to stock or an equity index without actually owning the stock. Forex. If an investor who has an investment in bonds can enter into an equity swap to take temporary advantage of market movement without liquidating his bond portfolio and investing the bond proceeds in the equities or index fundIndex FundIndex Funds is a form of mutual fund constructed to replicate and match the performance of a particular country's index like S&P, NASDAQ, etc., and helps investors take broad market exposure due to the amount invested in various stocks of the different sectors of the economy.read more.
  • Avoiding Transaction Costs – An investor can avoid transaction costs of equities’ trade by entering into an equity swap and gaining exposure to stocks or equity index.
  • Hedging Instrument – They can be used to hedge equity risk exposures. They can be used to forgo short-term negative returns of stocks without forging possession of the stocks. During the period of negative stock return, an investor can forgo the negative returns and also earn a positive return from the other leg of the swap (LIBOR, fixed rate of return, or some other reference rate).
  • Access to a Wider Range of Securities – Equity swaps can allow investors exposure to a wider range of securities than that is generally unavailable to an investor. For example – by entering into an equity swap, an investor can gain exposure to overseas stocks or equity indices without actually investing in the overseas country and can avoid complex legal procedures and restrictions.

Disadvantages of Equity Swaps

The following are disadvantages of equity swaps:

Conclusion

Equity swaps are used to exchange returns on a stock or equity index with some other cash flow (fixed rate of interest/ reference rates like labor/ or return on some other index or stock). It can be used to gain exposure to a stock or an index without actually possessing the stock. It can also be used to hedge the equity risk in times of negative return environments and are also used by investors to invest in a wider range of securities.

Recommended Articles

This has been a guide to what is Equity Swaps and its definition. Here we discuss examples of how equity swaps work along with advantages, disadvantages. You can learn more about accounting from the following articles –

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