An equity swap is a derivative contract between two parties that involves the exchange of one stream(leg) of equity-based cash flow linked to the performance of a stock or an equity index with another stream (leg) of fixed-income cash flows. These swaps are highly customizable and are traded over-the-counter. A party will enter into an equity swap with the objective of either obtaining equity return exposure for a period of time or hedge existing equity risk exposure for a period of time.
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How Does Equity Swap Work?
- When a firm is facing a financial crisis and is in the position to not repay its debts equity swap is one way to restructure its finances.
- An equity swap involves a notional principal, a specified duration, and predetermined payment intervals. Here one party pays the floating leg (LIBOR)and receives the returns on a pre-agreed-upon index of stocks which is based on the notional amount of the contract.
- Equity swaps are typically linked to fixed-rate or floating rate securities. LIBOR rates are a common benchmark set for the fixed income portion of equity swaps, which tend to be held at intervals of one year or more.
Types of Equity Swaps:
Equity swaps are of three types:
- An equity swap with the equity return paid against a fixed rate.
- An equity swap with the equity return paid against a floating rate.
- An equity swap with the equity return paid against another equity return.
Advantages and Disadvantages of Equity Swaps:
Pros of Equity Swap:
- Avoid Transaction Costs: One of the biggest advantages of equity swap is the avoidance of transaction costs associated with equity trades. It also provides tax benefits to the parties in contact.
- Hedge Against Negative Returns: This contract can be used in hedging risk exposures. An investor can enter into a swap agreement to mitigate the possible negative short-term impacts on the stock (such as macroeconomic trends that push the price of the stock down for the short term) without selling the stock.
- Access More Securities: Equity swap contracts may allow investing in securities that otherwise would be unavailable to an investor. By replicating returns from a stock, investors can overcome some legal restrictions without breaking the law.
- Exposure to Stock or Equity Index: Equity swaps can be used to gain exposure to the stock or an equity index without actually owning the stock.
Cons of Equity Swap:
Compared to other OTC derivative instruments, equity swaps are largely unregulated. New regulations are in process by the government to monitor the market. They don’t provide open-ended exposure to equity because they have termination dates. Equity swaps are traded in OTC markets and thus have a lot of credit risk involved. There is also a risk of the counterparty getting default on its payment obligation.
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- Equity swap can be understood with the help of the following example:
- Party A swaps $1 million at LIBOR + 0.10% against $1 million (S&P to the $1 million notional).
- Here, Party A will pay (to Party B) a floating interest rate of LIBOR +0.10% on the $1 million notional and would receive from Party B any increase in the S&P equity index based on the $1 million notional.
- In this example, assuming a LIBOR rate of 6% p.a. and a swap tenor of 180 days, the floating leg payer/equity receiver (Party A) would owe (6%+0.10%) * $1,000,000*180/360 = $30,500 to the equity payer/floating leg receiver (Party B).
- At the same date (after 180 days) if the S&P had appreciated by 10% from its level at trade commencement, Party B would owe 10%*$1,000,000 = $100,000 to Party A.
- Similar to other types of swaps contract, equity swaps are primarily used by financial institutions including investment banks, hedge funds, and lending institutions or large corporations.
- The interest rate leg is often referenced to LIBOR while the equity leg is often referred to as a major stock index such as the S&P 500.
- An equity swap should not be confused with a debt/equity swap, in which the obligations or debts of a company are exchanged for equity.
Author- Moksha Gala
About the Author – Currently, a graduate in the field of accountancy and finance. Commerce has been a part of my life now. Exploring the available choices, finance was always distinct among them. Credits, investments, and markets were always a part of my interest. So decided to embrace finance as a career for life.