Equity swap: definition, examples and how it works

In the financial sector, you can invest using a variety of derivative instruments. These are products built on other underlying assets that allow for more complex trading operations. The available derivatives include the equity swap, a particular type of flexible and customisable financial contract.

Similar in some ways to an interest rate swap, the equity swap is related to transactions involving equities. There are also variations such as currency swaps which involve the exchange of specified amounts in different currencies.

Let's look at the definition of equity swaps, including some examples, to get a better idea of how these products work and what their applications are in trading.

An equity swap is a contract for the exchange of future cash flows between two parties based on pre-set conditions. The cash flows are linked to the performance of an equity asset or a benchmark equity index over a specific period of time, with the exchange based on a notional nominal amount.

Basically, with an equity swap, two parties agree to exchange two cash flows. One is based on the performance of the equity or equity index chosen and the other linked to a fixed or floating interest rate.  Swaps are private agreements between parties who enter into a contract and agree to abide by its terms. As such they are traded in the over the counter (OTC) market.

Equity swaps can be tailored to the needs of traders, can help to better diversify a portfolio and also offer some potential tax benefits. Through an equity swap, you can hedge certain positions and assets in a portfolio, but you must assess the risk that the person you contract with (your counterparty) could default on your agreement.

Equity swap transactions are quite complex; however, think of them in terms of a contractually bound share swap. As a rule, the equity swap involves a party with a long position in shares and a counterparty wanting to replicate the returns on those shares without necessarily having to buy them.

When an investor believes that the shares in their portfolio may be affected by some short-term volatility, they can hedge the risk of a possible price drop through an equity swap and protect their position in the long term.

To do this they first have to find another party to contract with, for example, a fund manager willing to diversify their income.

The equity swap contract is then realised, with one side of the future cash flows to be exchanged tied to a reference interest rate (usually LIBOR) and the other to the future performance of the shares (or share index) chosen during the reference period.

No transactions take place at the beginning of the contract or at the end, only during the reference period of the equity swap, based on the interest rate and the performance of the shares (or share index).

As previously mentioned, an equity swap is a customisable private contract, so the counterparties can freely choose all the details of the agreement. For example, you can choose any type of equity index, replace LIBOR with another rate or apply basis points on LIBOR. You also have to define the notional nominal amount of the contract and the length of time it will be active and binding, although these contracts usually last for at least one year.

Let’s look at an example of an equity swap to show how this instrument works. Let's assume a finance company and a fund manager decide to enter into an equity swap, where they commit to pay the respective counterparty cash flows every six months: the finance company pays the fund manager a variable rate on £100,000 (the nominal sum) while the fund manager pays the finance company the performance of the FTSE 100 index over the same period and on the same nominal sum.

After six months, a review of market conditions takes place to determine the cash flow dynamics. If the variable rate increases by 6% and the FTSE 100 index only increases by 3%, the finance company pays the fund manager the difference in return of 3% on £100,000, namely £3,000. If, on the other hand, the variable rate increases by 3% and the FTSE 100 index rises by 6%, the fund manager pays the finance company the £3,000.

There are some similarities between equity swaps and CFDs; they are both derivative financial products and don’t require the purchase of the underlying asset. However, there are also several differences:

• An equity swap has an expiration date, whereas CFDs can be rolled over with no fixed expiry date.
• With an equity swap, the underlying asset of the contract is always a share or share index, while CFDs can have any type of asset as the underlyer, such as shares, commodities, currency pairs, indices and ETFs.
• Equity swaps are mainly used by large finance companies, while CFDs are also used by retail traders and professional investors.
• An equity swap can allow you to avoid paying capital gains tax if well structured, while gains from CFD trading are subject to taxation.

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