Equity SwapsExplained, Advantages & Disadvantages, and Examples

Written By:
Lisa Borga

An equity swap is a derivative contract under which two parties agree to exchange streams of future cash flows for a certain period of time while retaining their assets.

These contracts resemble interest rate swap agreements, but in contrast, these agreements do not include a “fixed” side.

Instead, one cash stream is determined on the basis of the return of the equity index.

In contrast, the other cash stream is based on a fixed-income cash flow.

This could be Euribor, SOFR, or Libor, among others.

The swaps in cash flows are nominally equal and will be exchanged as set out in the agreement.

The exchange could involve swapping a fixed-income cash flow for an equity-based cash flow, but it really depends on the agreement.

The Equity Swap Process

An equity swap involves two parties, for example, Party 1 and Party 2.

Suppose Party 1 agrees to pay Party 2 SOFR + 2% on $2 million notional principal.

In exchange for this, Party 2 agrees to pay Party 1 returns from the NASDAQ index on $2 million notional principal.

The parties agree to exchange cash flows at the end of every 180 days.

• Suppose the SOFR rate is 4% per annum in the example we gave, and the NASDAQ index rose by 8% by the end of the 180-day period.
• At the time of the exchange, Party 1 would need to pay Party 2 $60,000. [$2,000,000 x (.04 + .02) x 180/360]. Whereas, Party 2 would need to pay Party 1 8% on the NASDAQ index, which would be $160,000 ($2,000,000 x .08).
• After these payments are netted, Party 2 would pay Party 1 $100,000. The notional principle does not get exchanged. It is simply used to compute cash flows for the exchanges.
• It is not unusual for stock exchanges to have negative returns. If this does happen, the equity return payer will receive the negative equity return rather than paying the return to the other party involved.

To use the example above, suppose the stock return was – 2% for the period involved.

Party 2 would have received the $60,000 of (SOFR +2%) and $40,000 ($2,000,000 x .02) for the negative equity return.

This means Party 1 would pay Party 2 $100,000 for the first period of the equity swap contract.

Equity Swap Advantages

Here are some advantages of equity swaps.

• Equity swaps are a way for investors to gain the advantages of an equity index or stock without personally investing in it.
• If an investor participates in an equity swap to gain access to an equity index or stock, they can avoid the transaction costs they would have had to pay if they had personally invested in the equities.
• Equity swaps are a good way for an investor to gain exposure to a variety of securities that likely would otherwise have been unavailable.
• An investor can use an equity swap to hedge equity risk exposures.

Equity Swap Disadvantages

Here are some disadvantages of equity swaps.

• Equity Swaps are generally unregulated. Although, some governments are making regulations that will monitor the OTC derivatives market.
• With equity swaps, unlike with direct investments in the equity index or stocks, there is a credit risk. The counter-party may not meet its obligations.
• Equity swaps do have an expiration date. So, they do not give continuing exposure to equities.

Final Thoughts

Equity swaps are a way of exchanging a cash flow for a return on an equity index or stock.

They are useful for gaining access to an index or stock without having to directly invest in the stock. It is also a good way to invest in a larger variety of securities without having to actually purchase the securities.

Key Takeaways

• An equity swap is a lot like an interest rate swap. However, instead of having one leg as the fixed side, it is based off of the returns of a specific index, such as the S&P 500.
• Equity swaps can easily be customized and are traded through a broker-dealer network. Equity swaps typically take place between big financing companies, including investment banks and auto financiers, among others.
• The interest rate leg is typically based on the LIBOR. In contrast, the equity leg is generally based on a major stock index like the NASDAQ.
• Equity swaps are sometimes confused with debt/ equity swaps, but they are not the same. Debt/equity swaps are a kind of financial restriction where a company’s debts are converted into stock.
• Due to equity swaps being traded over the counter, they do involve a certain amount of counter-party risk.
• Equity swaps are a way for large institutions to hedge certain positions or assets that are a part of their portfolio.