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, Euribor, etc. As with other swaps in finance, variables of an equity swap are notional principal, the frequency at which cash flows will be exchanged, and the duration/ tenor of the swap.
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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- Assume a LIBOR rate of 5% per annum in the above example and appreciation of the S&P index by 10% at the end of 180 days from the commencement of the swap contract.
- At the end of 180 days, Party A will pay USD 1,000,000 * (0.05 + 0.01) * 180 / 360 = USD 30,000 to Party B. Party B would pay Party A return of 10% on the S&P index i.e. 10% * USD 1,000,000 = USD 100,000.
- The two payments will be netted off, and in net, Party B would pay USD 100,000 – USD 30,000 = USD 70,000 to Party A. It should be noted that the notional principal is not exchanged in the above example and is only used to calculate cash flows at the exchange dates.
- Stock returns experience negative returns very frequently, and in case of negative equity returns, the equity return payer receives the negative equity return instead of paying the return to its counterparty.
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 fund.
- 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:
- Like most of the other otc derivatives instruments, equity swaps are largely unregulated. Though new regulations are being formed by governments around the world to monitor the OTC derivatives market.
- Equity swaps, like any other derivatives contract, have termination/expiration dates. Thus, they don’t provide open-ended exposure to equities.
- Equity swaps are also exposed to credit risk, which doesn’t exist if an investor invests directly into stocks or equity index. There is always a risk that the counterparty may default on its payment obligation.
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.
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 –