What is an Equity Swap Contract?
An equity swap contract is a derivative contract between two parties that involves the exchange of one stream (leg) of equity-based cash flows linked to the performance of a stock or an equity index with another stream (leg) of fixed-income cash flows.
In equity swap contracts, the cash flows are based on a predetermined notional amount. However, unlike currency swaps, equity swaps do not imply the exchange of principal amounts. The exchange of cash flows occurs on fixed dates.
Equity swap contracts offer a great degree of flexibility; they can be customized to suit the needs of the parties participating in the swap contract. Essentially, equity swaps provide synthetic exposure to equities.
Advantages of Equity Swap Contracts
Equity swap contracts provide numerous benefits to the counterparties involved in derivative contracts, including:
1. Avoid transaction costs
One of the most common applications of equity swap contracts is the avoidance of transaction costs associated with equity trades. Also, in many jurisdictions, equity swaps provide tax benefits to the participating parties.
2. Hedge against negative returns
Equity swap contracts can be used in hedging risk exposures. The derivatives are frequently used to hedge against negative returns on a stock without forgoing the possession rights on it. For example, an investor holds some shares, but he believes that the recent macroeconomic trends will push the stock price down in the short term while substantially appreciating in the long term. Thus, he can enter the swap agreement to mitigate the negative short-term returns of stock without selling the shares.
3. Access more securities
Finally, equity swap contracts may allow investing in securities that otherwise would be unavailable to an investor. By replicating the returns from a stock through an equity swap, the investor can overcome certain legal restrictions without breaking the law.
Similar to other types of swap contracts, equity swaps are primarily used by financial institutions, including investment banks, hedge funds, and lending institutions or large corporations.
How Does an Equity Swap Contract Work?
In order to understand the mechanism behind currency swap contracts, let’s consider the following example. The manager of Fund A is willing to replicate the returns of ABC Corp.’s stock without purchasing the company’s actual shares.
On the other hand, Investor B holds a long position in the stocks of ABC Corp. Investor B believes that the company’s stock price will be volatile in the short term, thus he wants to hedge the potential risk of lower returns. Fund A and Investor B can create an equity swap contract with each other to achieve their respective goals. The swap will include the exchange of future streams of cash flows.
One leg of the swap will be paid by Fund A to Investor B and will be the stream of floating payments linked to the LIBOR index. Another swap’s leg will be paid by Investor B to Fund A and will be based on the future total returns of ABC Corp.’s stock for the specified period.
Both legs will be calculated using the notional principal amount. In this case, both parties agree that the notional principal amount of $5,000,000. Note that Fund A and Investor B will exchange principal amounts neither at the beginning of the contract nor on the maturity date.
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