In an equity swap, two parties agree to exchange a set of future cash flows periodically for s specified period of time. Once leg of the equity swap is pegged to a floating rate such as LIBOR or is set as a fixed rate. The cash flows on the other leg are linked to the returns from a stock or a stock index. The leg linked to the stock or the stock index is referred to as the equity leg of the swap.
Let’s take an example to understand the various aspects of an equity swap. Let’s say an asset manager who manages a fund called Alpha Fund follows a passive investment strategy and his portfolio tracks the S&P 500 Total Returns Index. The asset manager can enter into an equity swap contract with a counterparty say Goldman Sachs with the following terms:
Notional Principal: $100 million
Alpha Fund pays: Total returns on the S&P 500 Index
Goldman Sachs pays: Fixed 6%
Payments to be made at the end of every six months, that is, 30th June and 31st December
The swap has a maturity of 3 years.
Let’s see how the cash flows turn out in the first year. At the beginning, the S&P Total Return Index was at 2500 level, on 30th June it was 2600, and on 31st December it was at 2570. Let’s look at the cash flows in both the legs of the transaction.
|Alpha Pays||Goldman Pays|
|30th June||Return on index = 2600/2500 = 4%
=100,000,000 * 182/365 * 6%
|31st December||Return on index = 2570/2600 = -1.154%
Alpha pays nothing.
=100,000,000 * 183/365 * 6%
Let’s make a few observations from the above table:
- If the index returns are positive, Alpha Fund pays index returns to Goldman and Goldman pays fixed rate to Alpha.
- If the index returns are negative, Alpha pays nothing and Goldman pays the fixed rate plus any loss on the index returns. It’s as if Alpha sold out its positions in stocks and had a fixed rate position instead.
- The fixed payments are calculated on actual/365 basis.
- The amount of payment is not known till the last day of the payment.
- The net effect of the swap is that a position in an equity portfolio has been converted into a fixed income position.
An equity swap can be of three types: the first leg will be a fixed rate, a floating rate or an equity or index return, while the other let will always be an equity or index return. So, an equity swap can have both the legs as returns from two different equities or equity indexes.