An equity swap is a derivative contract in which two counterparties agree to exchange a set of their future cash flows on preset dates in the future. Structurally, equity swaps are very similar to plain vanilla interest rate swaps: there is a single notional principal and the structure is pay fixed/receive floating.
One party’s payments are based on the cash flows related to the performance of stock or an index. This is called the equity leg. The other payment is based on fixed income cash flow, such as a benchmark rate. However, there are many variations as to what constitutes the other leg.
Equity Swap Motivation: Commonly, a party will enter into an equity swap with the objective of either obtaining equity return exposure for a period of time or hedge existing equity risk exposure for a period of time.
Example of a simple equity index swap:
Party A swaps $1 million at LIBOR + 0.10% against $1 million (S&P to the $1 million notional).
In this case Party A will pay (to Party B) a floating interest rate of LIBOR +0.10% on the $1 million notional and would receive from Party B any increase in the S&P equity index based on the $1 million notional.
In this example, assuming a LIBOR rate of 6% p.a. and a swap tenor of 180 days, the floating leg payer/equity receiver (Party A) would owe (6%+0.10%)*$1,000,000*180/360 = $30,500 to the equity payer/floating leg receiver (Party B).
At the same date (after 180 days) if the S&P had appreciated by 10% from its level at trade commencement, Party B would owe 10%*$1,000,000 = $100,000 to Party A.
Negative Equity Returns: When analyzing the payments on an equity swap it is important to note that while interest rates are almost never negative, equity returns regularly experience periods of negative returns.
Example: In our example, with the equity index referenced in a swap is the S&P 500, with a notional principal of $1 million, if the index returned a negative 5% for the payment period, then the floating rate (equity index) payer/fixed interest rate receiver would actually receive $50,000 for the negative equity return on top of the fixed interest coupon payment.