Equity Swap

What Is an Equity Swap?

An equity swap is an exchange of future cash flows between two gatherings that permits each party to differentiate its income for a predetermined period of time while as yet holding its original assets. An equity swap is like an interest rate swap, but instead than one leg being the "fixed" side, it depends on the return of an equity index. The two arrangements of nominally equivalent cash flows are exchanged according to the terms of the swap, which might include an equity-based cash flow, (for example, from a stock asset called the reference equity) that is traded for fixed-income cash flow, (for example, a benchmark interest rate).

Swaps trade over-the-counter and are entirely adjustable in view of what the two gatherings consent to. Other than diversification and tax benefits, equity swaps permit large institutions to hedge specific assets or positions in their portfolios.

Equity swaps ought not be mistaken for a debt/equity swap, which is a restructuring transaction where the obligations or debts of a company or individual are exchanged for equity.

Since equity swaps trade OTC, there is counterparty risk implied.

How an Equity Swap Works

An equity swap is like an interest rate swap, yet rather than one leg being the "fixed" side, it depends on the return of an equity index. For instance, one party will pay the floating leg (normally linked to LIBOR) and receive the returns on a pre-settled upon index of stocks comparative with the notional amount of the contract. Equity swaps permit gatherings to possibly benefit from returns of an equity security or index without the need to possess shares, a exchange-traded fund (ETF), or a mutual fund that tracks an index.

Most equity swaps are directed between large financing firms, for example, auto agents, investment banks, and lending institutions. Equity swaps are normally linked to the performance of an equity security or index and incorporate payments linked to fixed rate or floating rate securities. LIBOR rates are a common benchmark for the fixed income portion of equity swaps, which will generally be held at time periods year or less, similar as commercial paper.

As per a declaration by the Federal Reserve, banks ought to stop composing contracts utilizing LIBOR toward the finish of 2021. The Intercontinental Exchange, the authority responsible for LIBOR, will stop distributing multi week and multi month LIBOR after December 31, 2021. All contracts utilizing LIBOR must be wrapped up by June 30, 2023.

The surge of payments in an equity swap is known as the legs. One leg is the payment stream of the performance of an equity security or equity index (like the S&P 500) over a predetermined period, which depends on the predefined notional value. The subsequent leg is regularly founded on the LIBOR, a fixed rate, or another equity's or alternately index's returns.

Illustration of an Equity Swap

Expect a passively managed fund looks to follow the performance of the S&P 500. The asset managers of the fund could go into an equity swap contract, so it wouldn't need to purchase different securities that track the S&P 500. The firm swaps $25 million at LIBOR plus two basis points with an investment bank that consents to pay any percentage increase in $25 million invested in the S&P 500 index for one year.

Therefore, in one year, the latently managed fund would owe the interest on $25 million, in light of the LIBOR plus two basis points. Notwithstanding, its payment would be offset by $25 million duplicated by the percentage increase in the S&P 500. On the off chance that the S&P 500 falls over the next year, the fund would need to pay the investment bank the interest payment and the percentage that the S&P 500 fell increased by $25 million. Assuming the S&P 500 ascents more than LIBOR plus two basis points, the investment bank owes the inactively managed fund the difference.

Since swaps are adaptable in light of what two gatherings consent to, there are numerous potential ways this swap could be rebuilt. Rather than LIBOR plus two basis points, we might have seen one bp, or rather than the S&P 500, another index could be utilized.

Features

• An equity swap is like an interest rate swap, but instead than one leg being the "fixed" side, it depends on the return of an equity index.
• These swaps are exceptionally adaptable and are traded over-the-counter. Most equity swaps are directed between large financing firms, for example, auto agents, investment banks, and lending institutions.
• The interest rate leg is frequently referenced to LIBOR while the equity leg is frequently referenced to a major stock index like the S&P 500.