Equity Swap

Key takeaways

• An equity swap is a private (over‑the‑counter) derivative in which two parties exchange cash flows tied to an equity return and a separate payment stream (typically a fixed or floating interest‑rate leg).
• It lets a party gain exposure to an equity index or stock return without owning the underlying shares.
• Equity swaps are highly customizable but carry counterparty and basis risks; since LIBOR’s phase‑out, alternative reference rates (e.g., SOFR, SONIA) are commonly used.

What is an equity swap?

An equity swap is a contractual agreement between two parties to exchange future cash flows over a set period. One cash‑flow leg is linked to the performance of an equity security or equity index (for example, the S&P 500). The other leg usually pays a fixed amount or a floating interest rate plus or minus a spread. No underlying securities need to change hands — only net cash payments are exchanged.

How equity swaps work

• Notional amount: The hypothetical principal used to calculate payments (the notional is not exchanged).
• Equity leg: Payment equals the return (price change plus dividends, if agreed) on the equity or index applied to the notional.
• Interest leg: Payment equals a fixed rate or a floating benchmark rate (historically LIBOR; now often SOFR, SONIA, etc.) applied to the notional.
• Net settlement: Only the difference between the two legs is paid by the party that owes more at each settlement date.
• Customization: Parties negotiate tenor, payment frequency, dividend treatment, collateralization, caps/floors, and other terms.

Practical example

A passively managed fund wants exposure to the S&P 500 without buying constituent stocks. It enters an equity swap with an investment bank on a $25 million notional:

• Fund agrees to pay the bank interest on $25 million equal to the benchmark rate plus a spread (e.g., benchmark + 2 basis points).
• The bank agrees to pay the fund the percentage return on $25 million invested in the S&P 500 for one year.

At settlement:
* If the S&P 500 rises more than the benchmark rate + spread, the bank pays the fund the difference.
* If the S&P 500 falls (or rises less than the benchmark + spread), the fund pays the bank the shortfall (interest plus any loss on the equity leg).

Because terms are negotiable, the benchmark, spread, notional, and reference index can be changed to suit both parties.

Benefits

• Exposure: Gain equity returns without purchasing shares (useful for regulatory, operational, or tax reasons).
• Hedging: Offset specific portfolio exposures without liquidating positions.
• Customization: Tailor terms to precise needs (index choice, dividend treatment, currency, tenor).
• Efficiency: Potentially lower transaction costs and operational complexity for large institutions.

Risks and considerations

• Counterparty risk: OTC contracts depend on the other party’s creditworthiness; collateral agreements and credit support annexes mitigate but do not eliminate this risk.
• Basis risk: Differences between the chosen benchmarks, actual holdings, or dividend treatments can create imperfect hedges.
• Liquidity and valuation: Valuing and unwinding bespoke swaps can be complex and costly.
• Regulatory and documentation requirements: ISDA agreements, margining rules, and local regulations affect structure and costs.
• Tax and accounting: Treatment varies by jurisdiction and contract details; consult advisors for implications.

Market developments and benchmarks

LIBOR has been largely phased out as a reference rate. Market participants now typically use alternative overnight or term risk‑free rates such as SOFR (U.S.), SONIA (U.K.), and €STR (euro area). Swaps may include fallback language and provisions to address benchmark transitions.

Bottom line

Equity swaps are flexible OTC derivatives that let parties exchange equity returns for fixed or floating payments without transferring the underlying assets. They are useful for gaining exposure, hedging, or achieving specific balance‑sheet or tax objectives, but require careful management of counterparty, valuation, and regulatory risks.