Equity Swaps

Investors can use equity swaps to exchange future cash flows. Such a derivative is helpful to design the risk exposure that meets one’s objectives. Legs of the swap refer to the segments that make up these cash flows.

First, there is a 'floating leg,' which is the leg based on the floating rate. As for the other, it's dependent on how well the asset is performing on the market. This is known as the 'equity leg' of the cash flow.

For total return swaps, the equity leg payment includes dividends paid for the underlying shares in addition to the principal amount. An interest rate or another equity index can serve as the basis for the return leg. Some structures have a fixed notional value for the exchange duration, while others have a variable value. There are a variety of payment schedules that can be used.

As a result of an equity swap, an investor gains access to a stock or index without buying the underlying stock themselves. In addition, by using these equity swaps, investors are able to reduce equity risk while also diversifying their portfolios.

How does it work?

An equity swap resembles an interest rate swap in many ways.  However, the big difference is that a  stock swap has two cash flow legs, whereas an interest rate swap just has one. If you do an equity swap, one party will make payments equivalent to the floating leg, and in return, the other party will receive returns on an agreed-upon index of the stock. 

Investors can earn index or equity security returns without purchasing shares, mutual funds, ETFs, or any other asset derivatives. Large financial institutions trade these equity swaps all the time.

In an equity swap, both parties are exposed to the other's credit. Whenever the price of the underlying share rises, the equity payer is expected to pay an amount equal to the increase, and when it declines, the equity payer is entitled to a payout. As a result, when the stock price drops, the equity payer faces credit risk, and when it rises, the risk is reversed.

Equity swaps are preferred to own shares because they accomplish economic benefits like avoiding nation-specific custodian transaction fees. It also helps them avoid the burden of having to keep massive volumes of data related to the historical performance of the asset. 

Practical illustration

Let's use the following example to understand better how stock swap contracts work. Let’s assume that Investor Z aims to duplicate Company Y's without buying or owning the stock.

However, Investor W is a long-term shareholder of Company Y. Investor Z is looking to protect himself against the possibility of the stock price decreasing in the near future. An equity swap contract can be created between Investor W and Investor Z in order to satisfy both parties' objectives. Future cash flow streams will be exchanged as part of the deal.

Advantages and disadvantages of equity swaps

Advantages

• Hedging against negative returns is possible with equity swap contracts. Negative returns on an identified asset can be hedged with derivatives without giving up ownership rights. 
• Suppose an investor owns some stock in a company, but he believes that recent changes in the market fundamentals may cause the stock price to fall in the short term. He may use equity swaps to cover the perceived risk in the short term. In other words, he uses the swap to reduce the stock's short-term risk without having to sell any of his shares.
• Some transaction costs can be avoided by using equity swap contracts. This is a popular use case for these contracts. They may also give tax advantages to the parties involved in the transaction.
• Stock swap contracts may make it possible for investors to invest in assets that they otherwise would not have access to. An investor can avoid breaking the law by simulating the stock's returns through an equity swap.

Disadvantages

• Equity swaps contain expiration or termination dates, making them ineffective for providing long-term exposure. Therefore, the expiration date may come before you achieve your intended goal.
• Lack of regulation: Equity swaps are often uncontrolled, in contrast to other derivative contracts that are subject to government regulation.
• There is always the risk of a counterparty defaulting on payment in a stock swap for a stakeholder.

In summary

To simulate a physical investment in stocks, investors can use equity swaps. They are transactions in which the return earned on the underlying stock is traded for an alternative return that is calculated using a reference interest rate or yield.

They enable investors to avoid the costs and intrigues of transactions associated with the initial acquisition of an asset. However, they come with a number of underlying risks that can lead to losses instead of the intended benefits. Investors should weigh these options and decide whether or not to choose these derivatives.