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An equity swap is a type of derivative contract in which two parties agree to exchange a series of cash flows at future dates. T
he two cash flows are frequently referred to as ‘legs,’ with one leg referred to as the ‘floating leg’ and the other as the ‘equity leg’.
Explanation
Equities swaps are a sort of financial derivative transaction in which two counterparties agree to exchange future cash flows at predetermined periods.
These cash flows are frequently referred to as the swap’s legs. One of these legs is floating rate-based, and so is referred to as the ‘floating leg’.
While the other leg is contingent upon the performance of the share, stock, or stock market index, among others.
As a result, the ‘equity leg’ of the cash flow is referred to as the ‘other leg.’
Characteristics of Equity Swaps
➣ An equity swap is quite similar to an interest rate swap, however unlike an interest rate swap, which has one fixed leg, equity swaps are dependent on the return of an equity index.
Typically, equity swaps are conducted between large financial institutions.
➣ It provides exposure to an equity index or the stock market without requiring ownership of the underlying stock.
➣ Stock swaps act as a hedge against the risk of exposure to equity swaps.
➣ Equity swaps have no transaction expenses.
How Does an Equity Swap Work?
Equities swaps are very similar to interest rate swaps. Unlike an interest rate swap, which has a single fixed side leg, an equity swap has two cash flow legs.
In an equity swap, one party pays the floating leg and receives returns on an agreed-upon stock index.
It enables parties to earn index or stock security returns without purchasing shares, mutual funds, or exchange-traded funds (ETFs), for example.
Typically, these are conducted between large financial institutions.
Examples of Equity Swaps
Assume an asset manager of a fund wishes to monitor the ‘S&P 500’ index’s performance.
Rather than acquiring various securities that track the S&P 500, the manager went into an equity swap contract with an investment bank, swapping $30 million for one year at LIBOR plus two basis points.
If the S&P 500 index falls during that year, the fund’s asset manager will be required to pay the investment bank $30 million multiplied by the percentage the S&P 500 declined.
Similarly, if the S&P 500 grows in that year, the investment bank must compensate the fund’s fund manager for the difference.
Various Types of Equity Swaps
Equity swap contracts are classified into three types as follows:
➣ Fixed interest rate swap: In this contract form, you pay a fixed rate of interest and earn returns on equity.
➣ Floating interest rate swap: In this sort of equity exchange, you pay a floating interest rate and obtain equity returns.
➣ Equity vs. equity: In such equity swap contracts, you pay interest on one type of stock and receive interest on another type of stock.
Equity Swaps in Practice
Equity swaps are typically engaged into to save transaction costs, to restrict leverage, or to avoid local dividend taxes.
However, equity swaps provide additional benefits, including the following:
➣ Normally, an investor loses possession of shares upon sale, but with an equity swap, an investor can distribute negative returns on an equity position without forfeiting voting rights or ownership of the shares.
➣ An equity swap enables investors to earn interest on shares that are unavailable to them due to legal restrictions.
Valuation of Equity Swaps
The swap’s value is the net present value of future cash flows that are netted against one another.
Initially, these two cash flows have zero values, but once traded, they can become positive or negative, depending on the underlying variables.
In stock swaps, the first leg, referred to as the floating leg, is evaluated by degrading it into a forwarding rate agreement; after that, the implied forward rates in the zero-coupon curve are utilized to value it.
The other leg, dubbed the ‘equity leg,’ is based on the performance of stock market stocks, or stock market indexes.
Option pricing techniques are used to value the equity leg. After valuing both of these legs, the value of the equity swap can be easily calculated by netting them out.
Benefits
Several of the benefits are listed below:
➣ Stock exchange exposure: It provides exposure to an equity index or the stock exchange without requiring the purchaser to purchase the stock.
➣ Hedging equity risk exposure: Equity swaps are advantageous for hedging equity risk exposure since they allow the investor to avoid short-term negative returns.
➣ No transaction costs: When an investor engages in equity swaps, he or she benefits from the absence of transaction expenses.
➣ Exposure to a broader range of assets: An equity swap enables investors to gain exposure to a broader range of securities that they might not have access to otherwise.
Downsides
Several downsides are listed below:
➣ Uncontrolled: Unlike other derivative transactions, stock swaps are typically unregulated.
➣ Expiration dates: Due to the fact that equity swaps have expiration or termination dates, they are inefficient for providing open-ended exposure.
➣ There is always the prospect of risk in an equity swap for an investment if the counterparty defaults on payment.
Conclusion
It is a type of derivative contract in which two parties agree to exchange the returns on an equity index for another type of cash flow.
An equity swap enables an investor to gain exposure to a stock or stock index without purchasing the shares.
These equity swaps assist investors in mitigating equity risk while also allowing them to participate in a broader selection of securities.