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What Is an Equity Swap?
Equity swaps allow parties to trade cash flows based on the performance of equity indices, facilitating income diversification and risk management. Unlike interest rate swaps, equity swaps hinge on the returns of an equity index, providing a customizable financial instrument for parties to exchange fixed or floating income payments against equity performance.
Key Takeaways
- An equity swap involves exchanging future cash flows, typically between a fixed income and an equity index’s return.
- These swaps can help parties diversify income and hedge portfolio assets while retaining the original assets.
- Equity swaps are customizable, traded over-the-counter, and can carry counterparty risk.
- The swaps often have one leg linked to a benchmark interest rate and another to an equity index like the S&P 500.
- An example of an equity swap might include a fund swapping the return on $25 million linked to the S&P 500 with an investment bank for interest payment at benchmark rates.
Swaps trade over-the-counter and are very customizable based on what the two parties agree to. Equity swaps offer diversification and tax benefits, and they help large institutions hedge specific assets or positions in their portfolios.
Equity swaps should not be confused with a debt/equity swap, which is a restructuring transaction in which the obligations or debts of a company or individual are exchanged for equity.
Equity swaps are traded over-the-counter, so there is a counterparty risk.
Understanding the Mechanics of an Equity Swap
An equity swap is similar to an interest rate swap, but rather than one leg being the “fixed” side, it is based on the return of an equity index. For example, one party will pay the floating leg (typically linked to LIBOR) and receive the returns on a pre-agreed-upon index of stocks relative to the notional amount of the contract. Equity swaps allow parties to potentially benefit from returns of an equity security or index without the need to own shares, an exchange-traded fund (ETF), or a mutual fund that tracks an index.
Most equity swaps are conducted between large financing firms such as auto financiers, investment banks, and lending institutions. Equity swaps are typically linked to the performance of an equity security or index and include payments linked to fixed rate or floating rate securities. LIBOR rates are a common benchmark for the fixed income portion of equity swaps, which tend to be held at intervals of one year or less, much like commercial paper.
Important
According to an announcement by the Federal Reserve, banks should stop writing contracts using LIBOR by the end of 2021. The Intercontinental Exchange, the authority responsible for LIBOR, will stop publishing one week and two month LIBOR after December 31, 2021. All contracts using LIBOR must be wrapped up by June 30, 2023.
The payment streams in an equity swap are called “legs.” One leg is the payment stream of the performance of an equity security or equity index (such as the S&P 500) over a specified period, which is based on the specified notional value. The second leg is typically based on the LIBOR, a fixed rate, or another equity’s or index’s returns.
Practical Example of an Equity Swap in Action
Assume a passively managed fund seeks to track the performance of the S&P 500. The asset managers of the fund could enter into an equity swap contract, so it would not have to purchase various securities that track the S&P 500. The firm swaps $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.
Therefore, in one year, the passively managed fund would owe the interest on $25 million, based on the LIBOR plus two basis points. However, its payment would be offset by $25 million multiplied by the percentage increase in the S&P 500. If the S&P 500 drops in the next year, the fund must pay the investment bank interest and the amount by which the S&P 500’s value fell, multiplied by $25 million. If the S&P 500 rises more than LIBOR plus two basis points, the investment bank owes the passively managed fund the difference.
Since swaps are customizable, two parties can agree on various ways to restructure the swap. Instead of LIBOR plus two basis points, we could have seen one bp, or instead of the S&P 500, another index could be used.
The Bottom Line
An equity swap is a financial derivative that allows two parties to exchange cash flows based on the performance of an equity index or asset. It offers institutions a customizable and strategic tool for diversification and hedging, without the need to hold the underlying securities.
These swaps typically involve counterparty risk and are executed over-the-counter, offering flexibility in terms and structure. With the phasing out of LIBOR, parties involved must consider alternative benchmarks for floating rates. Understanding equity swaps is crucial for institutions looking to manage portfolio risk efficiently while exploring opportunities for potential returns linked to equity markets.
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