Equity Swap Contract
Refers to a deal between two parties enforcing the exchange of future equity-based cash flows between the respective parties.
What is an Equity Swap Contract?
An equity swap contract is a deal between two parties enforcing the exchange of future equity-based cash flows between the respective parties. This leads to, among other things, each investor having a more diversified portfolio.
The contract is exercised, or the exchange is made on fixed schedules. Equity swaps deal with the exchange of cash flows rather than a principal amount, like in currency swaps.
In swaps, we use the term leg to refer to the side of the contract one party agrees to receive in exchange for the other leg, i.e., for what the other party is offering.
Cash flows exchanged between the two parties are:
- Cash flows or payments are based on an index or interest rate like, for example, LIBOR.
- Variable cash flows depend on the performance of the underlying equity or stock.
Notice that the exchange is between a fixed, i.e., constant cash flow, and a variable cash flow, indicating the difference between risk factors and returns.
Equity swap contracts are flexible and can be manipulated according to the party’s needs and requirements. This allows investors to choose the appropriate exposure to given equity, effectively hedging their investments and possibly providing tax benefits.
These swaps are similar to interest rate swaps. The key difference is that one side is the return of an equity index or variable rate rather than a fixed rate, usually conducted between investment banks, hedge funds, lenders, etc.
Advantages of Equity Swap Contracts
Equity swap contracts have multiple benefits for both parties involved, including:
1. Diversification:
Equity swap contracts give exposure to multiple assets, diversifying the portfolios of both parties.
2. Hedging:
Imagine an investor exposed to a particular stock, betting on it performing well in the long run. However, he believes it will temporarily perform badly in the short-term due to market conditions.
Instead of holding it, he can hedge the investment via equity swaps, mitigating possible losses without selling the underlying stock itself.
3. Taxes:
Equity swaps provide tax benefits for both parties, including zero transaction fees for the trades done within the contract, making it a solid alternative to investing directly in the public markets.
Equity swap contracts are used by all financial institutions like hedge funds, investment banks, etc. Equity swaps also allow investors to invest in securities that are not available publicly or to investors. They do this by aligning the contracts to exhibit or relate to the underlying stock’s returns.
Example Of Equity Swap Contract
Let us take an example where we deal with two parties, Firm A and Firm B, each offering an equity swap deal.
Firm A wants returns of a given stock, say “X,” without buying stock X. He, therefore, offers a deal where he would receive returns based on stock X’s performance. In exchange for the contract, he’ll make payments to Firm B.
Firm B owns stock X but is not sure about the short-term volatility of the stock and wants to keep it for the long term.
Firms A and B accept the equity swap contract. Firm A will offer payments based on the LIBOR index in return for stock X’s profits.
This lets Firm B hedge its position with something less risky without selling the underlying stock. Doing this saves transaction fees for both Firm A and B. This swap will be exercised by exchanging future cash flows.
Here, one leg is the returns of stock X, and the other is the payments based on the LIBOR index. Both parties agree on a notional principal amount of Y million dollars, depending on their requirements, i.e., how much of the underlying asset they want to swap.
Equity Swap Contract FAQs
Swap contracts are seen in all kinds of possible swaps between two parties:
- Equity contract swaps,
- Interest rate swaps,
- Currency swaps,
- Hybrid swaps, etc.
Each of them has different types of securities in each leg, described in their respective contacts.
A total return swap, similar to an equity swap, has a time-dependent (temporary) clause. One party offers payment based on index returns or a fixed amount in exchange for returns of a given asset, including all capital gains generated via the asset, like dividends, etc.
Equity swaps only deal with the exchange of cash flows, while total return swaps also include net return gained through dividends of the given assets. The legs of total return swaps can also have derivative contracts, such as futures and other riskier derivatives.
A swap has a couple of disadvantages, including:
- Swaps don’t add liquidity to the market and still carry the underlying default risk of a swapped asset.
- Swaps have a time limitation, meaning a fee is incurred if canceled early.
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