Equity Swaps Definition Example How Does Equity Swaps Work

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, EuriborEuriborEuribor stands for Euro Interbank Offer Rate, which is the interest rate at which European Union banks lend funds to one another. It is a benchmark and reference interest rate that changes daily and covers tenures 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.

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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.

Assume a LIBORLIBORLIBOR Rate (London Interbank Offer) is an estimated rate calculated by averaging out the current interest rate charged by prominent central banks in London as a benchmark rate for financial markets domestically and internationally, where it varies on a day-to-day basis inclined to specific market conditions.read more 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 equityNegative EquityA negative equity balance is one in which the liabilities in shareholder’s equity exceed the assets for reasons such as accumulated losses over years, high dividend payments, borrowing money instead of issuing new shares to cover accumulated losses, and amortization of intangibles.read more 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 fundIndex FundIndex Funds are passive funds that pool investments into selected securities.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:

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 marketDerivatives MarketThe derivatives market is that financial market which facilitates hedgers, margin traders, arbitrageurs and speculators in trading the futures and options that track the performance of their underlying assets.read more.Equity swaps, like any other derivatives contractOther Derivatives ContractDerivative Contracts are formal contracts entered into between two parties, one Buyer and the other Seller, who act as Counterparties for each other, and involve either a physical transaction of an underlying asset in the future or a financial payment by one party to the other based on specific future events of the underlying asset. In other words, the value of a Derivative Contract is derived from the underlying asset on which the Contract is based.read more, have termination/expiration dates. Thus, they don’t provide open-ended exposure to equities.Equity swaps are also exposed to credit riskCredit RiskCredit risk is the probability of a loss owing to the borrower’s failure to repay the loan or meet debt obligations. It refers to the possibility that the lender may not receive the debt’s principal and an interest component, resulting in interrupted cash flow and increased cost of collection.read more, 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.

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 is also used by investors to invest in a wider range of securities.