What is an Equity Swap?
What is an equity swap example?
How does it work in practice?
In this article, I will break down the notion of Equity Swap so you know all there is to know about it!
Keep reading as I have gathered exactly the information that you need!
Let’s define equity swaps, look at examples, and see how they work!
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Table of Contents
What Is An Equity Swap
An equity swap is the process of exchange future cash flow between investors holding different types of investments with the objective of diversifying their income without having to own the investment in new financial instruments.
In other words, Investor A (holding Asset A) will swap with Investor B (holding Asset B) the cash flow on Asset A in exchange for the cash flow of Asset B.
Equity swaps will typical have the following components:
- Swap legs
- Notional principal
- Payment intervals
- Specified duration
For example, if you own fixed-income security giving you fixed income over time, you can decide to “trade” or “swap” your cash flow for a year with another investor who owns a portfolio of stocks tracking the S&P 500.
This means, for one year, you will give the other investor your cash flow on your fixed income securities and the other investor will give you the returns in the S&P 500.
Equity swaps are typically done by large institutions such as investment banking firms, large lending institutions, or other types of financiers.
If you take a lending institution, they may have a lot of income coming from issuing loans and debt to others and so they know they can expect a certain amount of cash flow over the near future.
The lending institution can diversity its income by swapping its interest income coming from its loans with an investment banking firm that has a lot of exposure in stocks and equity securities.
The lending institution is able to keep its loans and earn cash flow following the trends of the equity markets whereas the investment bank can reduce exposure to the equity markets and get collect fixed income cash flow.
In an equity swap, you have two “legs”.
One leg generally represents an equity-based cash flow coming from stock assets also called reference equity.
This leg is called the equity leg.
The second leg will generally be a fixed income cash flow benchmarked against a particular interest rate (like LIBOR, fixed-rate, or another market rate of interest).
This leg is called the floating leg.
For instance, one leg of the swap could be an investor agreeing to give a rate of interest equivalent to LIBOR + 3 basis points whereas the other leg of the swap may be a percentage increase in the S&P 500.
It’s very common that the interest rate leg is referenced against the LIBOR rate whereas the equity leg in a swap is referenced against a stock index similar to the S&P 500.
An equity swap involves a notional principal.
In other words, the notional principal is the principal value based on which the parties enter into an equity swap.
Consider the notional principal as the swap face value or principal value based on which interest will be calculated or payments will be defined.
Swaps are highly customizable types of financial derivative contracts.
As a result, the parties to swap can determine the periodic payments under the contract.
One way is to make payments at a set payment interval or another way is to make one single payment upon the maturity of the swap (also called a bullet swap).
For example, one party may agree to pay floating interest at a rate of $10,000,000 at LIBOR + 2 basis points in exchange for a $10,000,000 return on FTSE or S&P500 or the Dow Jones Industrial Average.
The parties may choose to leave the payment to be made upon the maturity of the swap expected to be in six months.
Equity Swap Definition
According to Investopedia, an equity swap is defined as:
An equity swap is an exchange of future cash flows between two parties that allows each party to diversify its income for a specified period of time while still holding its original assets.
As you can see from this definition, an equity swap is:
- The exchange between two parties
- Of future cash flows
- For a specified period of time
- While still holding their assets
- With the objective to diversify their income
For example, if an investor has investments giving it a stream of cash flows, it can swap its cash flows for the cash flows of a sort of equivalent investment.
The equity swap is similar to an interest rate swap with the difference that one leg in an equity swap is based on the cash flows coming from stocks (like indices) and the other leg is based on a benchmark rate of interest (like LIBOR).
The Federal Reserve has announced that banks must no longer write contracts using the LIBOR rates by the end of 2021.
In addition to that, the Intercontinental Exchange will no longer publish LIBOR rates as it used to for one week and two months LIBOR.
As a result, all banks that have been used to the practice of equity swaps where one leg was pegged against LIBOR must stop such practice as per the Federal Reserve requirement.
In addition to that, the banks are given a grace period to wind down all their contracts using LIBOR so they can comply with the new requirements.
How Do Equity Swaps Work
Equity swap refers to the process of parties exchanging cash flows or returns on investment instruments they own without having to sell the actual instrument.
For example, if you have a large bank earning a significant amount of income through fixed income securities, it may choose to trade the cash flow on the fixed income securities without selling the securities in question.
The way the bank could trade the income on the fixed income securities is by entering into a swap contract with another institution, such as an investment banking firm, that has earnings or cash flows from equity investments that it would like to trade.
In this case, the bank will keep its fixed income securities and swap its cash flows for the cash flows or returns generated on the equity securities owned by the investment banking firm.
In this case, the equity swap has two legs:
- Interest rate leg: this is one leg of the swap where the cash flow is linked to a benchmark rate of interest, a fixed rate, or based on another benchmark
- Equity leg: this is the other side of the swap transaction linked to the performance of equity securities or an equity index
Equity Swap Advantage
What are the advantages of entering into equity swap transactions?
If you compare equity swaps to standard equity investments, you may have the following benefits:
- An investor will be able to pass on the negative returns on an equity position to another investor without having to sell the underlying equity securities
- An investor can take advantage of equity-type gains by trading set cash flows
- An investor can generate a return on equity by investing in markets where it may not be authorized to transact due to legal reasons, capital control reasons, or other
- An investor can hedge riks by taking certain swap positions
The most notable advantages or benefits of equity swaps are to avoid transaction costs and hedge against negative returns.
As you can see, the advantages in equity swaps tend to favor large institutional investors, investment banks, large financial institutions, or corporations.
Equity Swap Disadvantages
Just like with any investment instrument or derivative, you’ll have benefits but also drawbacks.
What are the drawbacks to equity swaps?
The most notable drawback is that getting into an equity swap, you’ll need to transact on the over-the-counter market (OTC) which is an unregulated marketplace.
Even though there are some regulations protecting the OTC participants, you will not find the same level of protection and regulation as in the tightly regulated stock markets and other financial markets.
Another aspect to consider is that equity swaps, just like option contracts or other derivative products, have a set termination date and will expire.
As a result, when you open an equity swap position, you must ensure that you are comfortable with the timelines.
A third crucial disadvantage is that you are dealing with a counterparty who may respect its contractual obligations and make the necessary payment or default on its payment obligations.
In this context, the equity swap investor must accept some level of credit risk in case the other contracting party fails to make the required payments.
Over The Counter Market
Swaps, swap stocks, swap indices, equity swaps are all typically traded in the over-the-counter market.
In essence, when two financial institutions, traders, parties agree on the terms of the swap, they can enter into a swap contract (or equity swap contract) allowing them to mutually define the terms and conditions of their agreement.
As such, since the swapping parties are able to mutually define the terms of their swap, equity swaps are highly customizable investment options that can be tailor-fitted for a specific purpose, objective, and for a specific period of time.
The main reason why investors swap income or swap cash flows is to further diversify their portfolios and manage risk.
Large institutions can also enter into equity swap deals to implement tax strategies and benefit from certain tax advantages in swapping their cash flows through equity index swap deals, trading on swap, or entering into a stock swap agreement.
You have to keep in mind that over-the-counter markets are not as regulated as the financial exchanges.
As a result, parties entering into a swap agreement will be exposed to some level of counterparty risk.
Equity Swap Valuation
How do you calculate the value of the equity swap?
What is the equity swap valuation?
Essentially, you must take the net present value of the equity swap cash flows to find its value.
The floating leg is valued by deteriorating it into a forwarding rate agreement and then the implied forward rates are used in the zero-coupon curve.
The equity leg is valued based on the option pricing techniques as you must value the performance of the stock linked to the market performance.
Equity Swap Example
Let’s look at an example of how an equity swap can be used in real-life between financial institutions.
Imagine that you have a portfolio manager of a fund (Passive Fund) that is passively managed in an attempt to keep fund management fees and transaction costs low looking to earn some return that mimics the returns of the S&P 500 but does not want to buy the actual stocks to track the S&P 500.
You have another portfolio manager of a hedge fund (Active Fund) highly active in stock investments and is looking to take advantage of certain tax breaks through an equity swap.
Since an equity swap contract is negotiated over the counter, Passive Fund and Active Fund mutually negotiate the terms of a swap deal according to the following parameters:
- Passive Fund will owe interest on $100,000,000 to Active Fund at a fixed rate of interest or benchmarked against market rates of interest
- Active Fund will owe an amount equal to the increase in the value of the S&P index
- The contract is for a year
If in the course of the year, the S&P index increases in value, the Active Fund will need to pay the Passive Fund the amount equivalent to the increase and the Passive Fund will need to pay the Active Fund an amount equal to the agreed rate of interest.
However, the actual payment will represent the netting of what the Passive Fund is entitled to receive and what it owes (same for the Active Fund).
Equity Swaps Takeaways
So there you have it folks!
What is a stock swap?
What does it mean to have an equity-linked swap?
An equity swap is defined as a derivative contract between two investing parties exchange future cash flows where one leg of the swap depends on fixed-income cash flows whereas the other leg of the swap is determined based on equity-based cash flows.
Share swaps have certain key variables, namely:
- A notional principal value
- Cash flow exchange frequency
- Duration (or swap tenor)
For instance, you and I can enter into an equity swap where I agree to pay you interest on the notional principal of $10,000 at a rate LIBOR + 2% whereas you provide me with the returns on the S&P index for $10,000.
We can agree that our cash flows will be exchanged in 180 days from now.
Once the swap contract matures, I have to pay you amount of representing the interest on $10,000 at a rate of LIBOR + 2% and you will have to provide me with the returns on the S&P Index (positive equity returns or negative equity returns).
My payment and your payment will be offset against one another leaving one swapping party to have to make an effective payment to the other.
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