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An equity swap is a financial derivative contract a swap where a set of future cash flows are agreed to be exchanged between two counterparties at set dates in the future. The two cash flows are usually referred to as "legs" of the swap; one of these "legs" is usually pegged to a floating rate such as LIBOR.
This leg is also commonly referred to as the "floating leg". The other leg of the swap is based on the performance of either a share of stock or a stock market index.
This leg is commonly referred to as the "equity leg". Most equity swaps involve a floating leg vs. An equity swap involves a notional principala specified duration and predetermined payment intervals. The term "tenor" may refer either to the duration or the coupon frequency.
Equity swaps are typically traded by Delta One trading desks. Parties may agree to make periodic payments or a single payment at the maturity of the swap "bullet" swap. For mitigating credit exposure, the trade can be reset, or "marked-to-market" during its life. In that case, appreciation or depreciation since the last reset is paid and the notional is increased by any payment to the floating leg payer pricing rate receiver or decreased by any payment from the floating leg payer pricing rate receiver.
Equity swaps have many applications. They most often occur when a manager of a fixed income portfolio wants the portfolio to have exposure to the equity markets either as a hedge or a position.
These types of swaps are usually inexpensive and require little in terms of administration. Typically equity swaps are entered into in order to avoid transaction costs including Taxto avoid locally based dividend taxes, limitations on leverage notably the US margin regime or to get around rules governing the particular type of investment that an institution can hold. Equity swaps, if effectively used, can make investment barriers vanish and help an investor create leverage similar to those seen in derivative products.
Investment banks that offer this product usually take a riskless position by hedging the client's position with the underlying asset. For example, the client may trade a swap — say Vodafone.
The bank credits the client with 1, Vodafone at GBP1. The bank pays the return on this investment to the client, but also buys the stock in the same quantity for its own trading book 1, Vodafone at GBP1. Any equity-leg return paid to or due from the client is offset against realised profit or loss on its own investment in the underlying asset. The bank makes its money through commissions, interest spreads and dividend rake-off paying the client less of the dividend than it receives itself.
It may also use the hedge position stock 1, Vodafone in this example as part of a funding transaction such as stock lending,repo or as collateral for a loan. From Wikipedia, the free encyclopedia.
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