Define equity swaps

Equity swaps is a derivative contract between parties, which involves exchange of future cash flows between two cash streams. Cash streams are also called “leg”. One cash stream/leg has equity based cash flows (return on equity index etc.) and the other cash stream has fixed income cash flows (LIBOR etc.)

In this, exchange takes place on fixed dates and these cash flows have predetermined notional amounts. They do not imply exchange of principal amounts. They offer a high degree of flexibility and equity swap contracts are customised according to needs of parties.

Advantages of equity swaps are as follows −

• Gain exposure to equity/stock index.
• Transaction costs are avoided.
• Hedge equity risk exposures.
• Wider ranger securities exposure to investors.

Disadvantages of equity swaps are as follows −

• It is unregulated.
• These swaps don’t have an open ended exposure.
• Equity swaps are exposed to credit risk.

Example

Two parties enter into equity swap. One party agrees to pay another on USD 2 million notional principal and party B will pay S&P index on USD 2 million notional principal in return.

(a) ⇒ first party pays $ 2million (LIBOR+1%) notional principal

(b) ⇒ second party pays $ 2 million (S&P index) notional principal

(Assuming LIBOR rate of 4%/annum, S&P index by 8% in 180 days from commencement of contract)

Notional principle is used only for calculation purposes.

Solution

First Party pays ⇒ 2000000 * (4% + 1%) * (180/360) ⇒ 100000 ⇒ USD 50000

Second party pays ⇒ 2000000 * 8% ⇒ USD 160000

Payment netted off ⇒ 160000 – 50000 ⇒ USD 110000

(If market experiences negative returns then equity payer receives negative returns instead of paying the return to second party)

Conclusion

• Exchange return on stock/equity index with some other cash flows.
• Without actually possessing exposure to stock/equity index is gained.
• In times of negative returns it can be used to hedge.
• Investors can invest their money in a wide range of securities.