Equity Swaps

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: 

1. An equity swap with the equity return paid against a fixed rate. 
2. An equity swap with the equity return paid against a floating rate. 
3. An equity swap with the equity return paid against another equity return. 

Advantages and Disadvantages of Equity Swaps:

 

Pros of  Equity Swap: 

1. 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. 
2. 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. 
3. 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. 
4. 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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Example:

• 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.

Key Takeaways:

• 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.

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