Equity swap
Encyclopedia
An equity swap is a financial derivative contract (a swap
) where a set of future cash flows are agreed to be exchanged between two counterparties at set dates in the future. The two cash flows are usually referred to as "legs" of the swap; one of these "legs" is usually pegged to a floating rate such as LIBOR. This leg is also commonly referred to as the "floating leg". The other leg of the swap is based on the performance of either a share of stock
or a stock market index
. This leg is commonly referred to as the "equity leg". Most equity swaps involve a floating leg vs. an equity leg, although some exist with two equity legs.
An equity swap involves a notional principal
, a specified tenor and predetermined payment intervals.
Equity swaps are typically traded by Delta One
trading desks.
Take a simple index swap where Party A swaps £5,000,000 at LIBOR + 0.03% (also called LIBOR + 3 basis point
s) against £5,000,000 (FTSE
to the £5,000,000 notional).
In this case Party A will pay (to Party B) a floating interest rate (LIBOR +0.03%) on the £5,000,000 notional and would receive from Party B any percentage increase in the FTSE equity index applied to the £5,000,000 notional.
In this example, assuming a LIBOR rate of 5.97% p.a. and a swap tenor of precisely 180 days, the floating leg payer/equity receiver (Party A) would owe (5.97%+0.03%)*£5,000,000*180/360 = £150,000 to the equity payer/floating leg receiver (Party B).
At the same date (after 180 days) if the FTSE had appreciated by 10% from its level at trade commencement, Party B would owe 10%*£5,000,000 = £500,000 to Party A.
If, on the other hand, the FTSE at the six-month mark had fallen by 10% from its level at trade commencement, Party A would owe an additional 10%*£5,000,000 = £500,000 to Party B, since the flow is negative.
For mitigating credit exposure, the trade can be reset, or "marked-to-market" during its life. In that case, appreciation or depreciation since the last reset is paid and the notional is increased by any payment to the pricing rate payer or decreased by any payment from the floating leg payer.
Equity swaps also provide the following benefits over plain vanilla equity investing:
1. An investor in a physical holding of shares loses possession on the shares once he sells his position. However, using an equity swap the investor can pass on the negative returns on equity position without losing the possession of the shares and hence voting rights.
For example, let's say A holds 100 shares of a Petroleum Company. As the price of crude falls the investor believes the stock would start giving him negative returns in the short run. However, his holding gives him a strategic voting right in the board which he does not want to lose. Hence, he enters into an equity swap deal wherein he agrees to pay Party B the return on his shares against LIBOR+25bps on a notional amt. If A is proven right, he will get money from B on account of the negative return on the stock as well as LIBOR+25bps on the notional. Hence, he mitigates the negative returns on the stock without losing on voting rights.
2. It allows an investor to receive the return on a security which is listed in such a market where he cannot invest due to legal issues.
For example, let's say A wants to invest in company X listed in Country C. However, A is not allowed to invest in Country C due to capital control regulations. He can however, enter into a contract with B, who is a resident of C, and ask him to buy the shares of company X and provide him with the return on share X and he agrees to pay him a fixed / floating rate of return.
Equity swaps, if effectively used, can make investment barriers vanish and help an investor create leverage similar to those seen in derivative products.
Investment banks that offer this product usually take a riskless position by hedging
the client's position with the underlying asset. For example, the client may trade a swap - say Vodafone. The bank credits the client with 1,000 Vodafone at GBP1.45. The bank pays the return on this investment to the client, but also buys the stock in the same quantity for its own trading book (1,000 Vodafone at GBP1.45). Any equity-leg return paid to or due from the client is offset against realised profit or loss on its own investment in the underlying asset. The bank makes its money through commissions, interest spreads and dividend rake-off (paying the client less of the dividend than it receives itself). It may also use the hedge position stock (1,000 Vodafone in this example) as part of a funding transaction such as stock lending,repo or as collateral for a loan.
Swap (finance)
In finance, a swap is a derivative in which counterparties exchange certain benefits of one party's financial instrument for those of the other party's financial instrument. The benefits in question depend on the type of financial instruments involved...
) where a set of future cash flows are agreed to be exchanged between two counterparties at set dates in the future. The two cash flows are usually referred to as "legs" of the swap; one of these "legs" is usually pegged to a floating rate such as LIBOR. This leg is also commonly referred to as the "floating leg". The other leg of the swap is based on the performance of either a share of stock
Stock
The capital stock of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors...
or a stock market index
Stock market index
A stock market index is a method of measuring a section of the stock market. Many indices are cited by news or financial services firms and are used as benchmarks, to measure the performance of portfolios such as mutual funds....
. This leg is commonly referred to as the "equity leg". Most equity swaps involve a floating leg vs. an equity leg, although some exist with two equity legs.
An equity swap involves a notional principal
Notional amount
The notional amount on a financial instrument is the nominal or face amount that is used to calculate payments made on that instrument...
, a specified tenor and predetermined payment intervals.
Equity swaps are typically traded by Delta One
Delta One
Delta One products are a class of financial derivative that have no optionality and as such have a delta of one - that is to say that for a given percentage move in the price of the underlying asset there will be a near identical move in the price of the derivative...
trading desks.
Examples
Parties may agree to make periodic payments or a single payment at the maturity of the swap ("bullet" swap), the worst case.Take a simple index swap where Party A swaps £5,000,000 at LIBOR + 0.03% (also called LIBOR + 3 basis point
Basis point
A basis point is a unit equal to 1/100 of a percentage point or one part per ten thousand...
s) against £5,000,000 (FTSE
FTSE
FTSE may refer to:* The FTSE Group* Stock market indices published by the FTSE Group, particularly the FTSE 100 Index on the London Stock Exchange* The Fundamental theorem of software engineering...
to the £5,000,000 notional).
In this case Party A will pay (to Party B) a floating interest rate (LIBOR +0.03%) on the £5,000,000 notional and would receive from Party B any percentage increase in the FTSE equity index applied to the £5,000,000 notional.
In this example, assuming a LIBOR rate of 5.97% p.a. and a swap tenor of precisely 180 days, the floating leg payer/equity receiver (Party A) would owe (5.97%+0.03%)*£5,000,000*180/360 = £150,000 to the equity payer/floating leg receiver (Party B).
At the same date (after 180 days) if the FTSE had appreciated by 10% from its level at trade commencement, Party B would owe 10%*£5,000,000 = £500,000 to Party A.
If, on the other hand, the FTSE at the six-month mark had fallen by 10% from its level at trade commencement, Party A would owe an additional 10%*£5,000,000 = £500,000 to Party B, since the flow is negative.
For mitigating credit exposure, the trade can be reset, or "marked-to-market" during its life. In that case, appreciation or depreciation since the last reset is paid and the notional is increased by any payment to the pricing rate payer or decreased by any payment from the floating leg payer.
Applications
Typically equity swaps are entered into in order to avoid transaction costs (including Tax), to avoid locally based dividend taxes, limitations on leverage (notably the US margin regime) or to get around rules governing the particular type of investment that an institution can hold.Equity swaps also provide the following benefits over plain vanilla equity investing:
1. An investor in a physical holding of shares loses possession on the shares once he sells his position. However, using an equity swap the investor can pass on the negative returns on equity position without losing the possession of the shares and hence voting rights.
For example, let's say A holds 100 shares of a Petroleum Company. As the price of crude falls the investor believes the stock would start giving him negative returns in the short run. However, his holding gives him a strategic voting right in the board which he does not want to lose. Hence, he enters into an equity swap deal wherein he agrees to pay Party B the return on his shares against LIBOR+25bps on a notional amt. If A is proven right, he will get money from B on account of the negative return on the stock as well as LIBOR+25bps on the notional. Hence, he mitigates the negative returns on the stock without losing on voting rights.
2. It allows an investor to receive the return on a security which is listed in such a market where he cannot invest due to legal issues.
For example, let's say A wants to invest in company X listed in Country C. However, A is not allowed to invest in Country C due to capital control regulations. He can however, enter into a contract with B, who is a resident of C, and ask him to buy the shares of company X and provide him with the return on share X and he agrees to pay him a fixed / floating rate of return.
Equity swaps, if effectively used, can make investment barriers vanish and help an investor create leverage similar to those seen in derivative products.
Investment banks that offer this product usually take a riskless position by hedging
Hedge (finance)
A hedge is an investment position intended to offset potential losses that may be incurred by a companion investment.A hedge can be constructed from many types of financial instruments, including stocks, exchange-traded funds, insurance, forward contracts, swaps, options, many types of...
the client's position with the underlying asset. For example, the client may trade a swap - say Vodafone. The bank credits the client with 1,000 Vodafone at GBP1.45. The bank pays the return on this investment to the client, but also buys the stock in the same quantity for its own trading book (1,000 Vodafone at GBP1.45). Any equity-leg return paid to or due from the client is offset against realised profit or loss on its own investment in the underlying asset. The bank makes its money through commissions, interest spreads and dividend rake-off (paying the client less of the dividend than it receives itself). It may also use the hedge position stock (1,000 Vodafone in this example) as part of a funding transaction such as stock lending,repo or as collateral for a loan.