An Equity Swap is an exchange of cash flows between two parties that allows each party to diversify its income, while still holding its original assets. The two sets of nominally equal cash flows are exchanged as per the terms of the swap, which may involve an equity-based cash flow that is traded for a fixed-income cash flow. Besides diversification and tax benefits, equity swaps also allow large institutions to hedge specific assets or positions in their portfolios.
In other words, An equity swap is a financial derivative contract 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.
Like any other swap, an equity swap involves a notional principal, a specified tenor and predetermined payment intervals.
Most equity swaps today are conducted between large financing firms such as auto financiers, investment banks and capital lending institutions. LIBOR rates are a common benchmark for the fixed income portion of equity swaps, which also tend to be held at intervals of one year or less, much like commercial paper.
Applications
Equity Swaps provide the following benefits over plain equity investing:
1. An investor of an equity swap 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.
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.
Equity Swaps, if effectively used, can make investment barriers vanish and help an investor create leverage similar to those seen in derivative products.