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 always the case. Swaps are very customizable, based on what two parties agree to. Besides diversification and tax benefits, equity swaps allow large institutions to hedge specific assets or positions in their portfolios.

Breaking Down the Equity Swap

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.

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's or index's returns.

Equity Swap Example

Assume a passively managed fund seeks to track the performance of the Standard & Poor's 500 index (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 falls over the next year, then the fund would have to pay the investment bank the interest payment and the percentage that the S&P 500 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 based on what two parties agree to, there are many potential ways this swap could be restructured. Instead of LIBOR plus two basis points, another index could be used, for example.