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 while still retaining its original assets. Unlike an interest rate swap, which features a ‘fixed’ side, an equity swap is based on the return of an equity index. The two sets of nominally equal cash flows are exchanged according to the terms of the swap, which may involve an equity-based cash flow (such as from a stock asset known as the reference equity) that is traded for fixed-income cash flow (such as a benchmark interest rate).
Key Takeaways
- An equity swap offers diversity from its similarities with interest rate swaps but revolves around the return of an equity index rather than a single interest rate.
- These swaps provide high customizability and are traded over-the-counter. Most equity swaps occur between large financing sectors, including auto financiers, investment banks, and lending institutions.
- The interest rate leg is commonly referenced to benchmarks like LIBOR, while the equity leg is often pegged to significant stock indices, such as the S&P 500.
Over-the-counter nature allows equity swaps to be highly customizable based on the agreement between the two parties. Apart from diversification and tax benefits, these swaps enable large institutions to hedge specific assets or positions in their portfolio. However, due to their OTC nature, equity swaps involve counterparty risks.
Note: Equity swaps shouldn’t be confused with a debt/equity swap, a restructuring transaction where obligations or debts are traded for equity.
How Equity Swaps Work
An equity swap functions similarly to an interest rate swap, but instead of one leg being ‘fixed’, it is linked to the return of an equity index. For instance, one party might pay the floating leg, usually linked to LIBOR, and receive returns on a pre-agreed-upon stock index relative to the notional amount of the contract. This agreement benefits parties by allowing them to gain from the returns of an equity security or index without needing to own actual shares, an ETF, or a mutual fund tracking that index.
Most equity swaps are facilitated between large financing firms such as auto financiers, investment banks, and lending institutions. These swaps are typically connected to the performance of an equity security or index and include payments related to fixed-rate or floating-rate securities. Traditionally, LIBOR rates have served as a common benchmark for the fixed-income portion of equity swaps, often held in intervals of one year or less, akin to commercial paper. However, as of June 30, 2023, new contracts using LIBOR ceased to be issued.
Payment streams in equity swaps are referred to as ’leg s’. One leg represents payments based on the performance of an equity security or index over a set period according to the specified notional value. The second leg frequently relies on benchmarks like LIBOR, a fixed rate, or another equity/index’s returns.
Example of an Equity Swap
Consider a passively managed fund aiming to track the S&P 500 performance. The fund’s asset managers might use an equity swap contract instead of purchasing various securities that mimic the S&P 500. In this scenario, the firm could swap $25 million at LIBOR plus two basis points with an investment bank that agrees to pay any percentage increase in $25 million invested in the S&P 500 index for one year.
In this case, after one year, the passively managed fund would owe interest on $25 million based on LIBOR plus two basis points. However, this payment would be counterbalanced by $25 million multiplied by the percentage increment in the S&P 500. If the S&P 500 reduces over the year, the fund must pay the investment bank both the interest and the percentage reduction, multiplied by $25 million. Conversely, if the S&P 500 grows more than LIBOR plus two basis points, the investment bank must pay the passively managed fund the difference.
The high customizability of swaps implies that agreements can be tailored substantially based on parties’ preferences. Instead of LIBOR plus two basis points, another basis point rate or equity index could be employed.
Related Terms: interest rate swaps, equity index, LIBOR, fixed income, commercial paper.
References
- Intercontinental Exchange. “LIBOR®”.
