What is an 'Equity Swap'

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 of time 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 (such as from a stock asset) that is traded for a fixed-income cash flow (such as a benchmark rate), but this is not necessarily the case. Besides diversification and tax benefits, equity swaps also allow large institutions to hedge specific assets or positions in their portfolios.

BREAKING DOWN 'Equity Swap'

Equity swaps allow parties to potentially benefit from returns of an equity security or index without the need to own shares of the security, an exchange-traded fund (ETF) or a mutual fund that tracks an index.

Most equity swaps today are conducted between large financing firms such as auto financiers, investment banks and capital 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 also tend to be held at intervals of one year or less, much like commercial paper.

Equity Swap Legs

The stream of payments in an equity swap is known as the legs. One leg is the payment stream of the performance of an equity security or equity index 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 security's or equity index's returns.

Equity Swap Example

Assume hypothetical investment management firm Alpha Management has a passively managed fund that seeks to track the performance of the Standard & Poor's 500 index (S&P 500). The asset managers of the index tracking fund could enter into an equity swap contract, so it would not have to purchase various securities that track the S&P 500. Alpha Management swaps $25 million at LIBOR plus 2 basis points with hypothetical investment bank Volatility Investments, which agrees to pay any percentage increase in $25 million invested in the S&P 500 index for one year.

Therefore, in one year, Alpha Management would owe the interest on $25 million, based on the LIBOR plus 2 basis points. However, its payment would be offset $25 million multiplied by the percentage increase in the S&P 500. If the S&P 500 falls over the next year, then Alpha Management would have to pay Volatility Investments the interest payment and the percentage that the S&P 500 fell multiplied by $25 million.

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