What are “Equity Swaps”?
A financial ‘Swap’ is where two counterparties enter into a derivative contract – they agree to exchange cash flows over a period of time. An ‘Equity Swap’ is where one of those cash flows being exchanged is the return on the equity index. It is a derivative contract where one party agrees to pay the return on an equity index and the other agrees to pay a fixed or floating interest rate. An example would be if a client (one party) is paying interest (LIBOR), whereas the bank (another party) is agreeing to pay the return on the S&P 500 index. The outcome of this swap is that the client is in a position of having effectively borrowed money to invest in the securities of the S&P 500 index.
Had they done that, the client would have to pay interest on the money that they borrowed and they would be earning the return on the S&P 500 index. However, with the swap, the client does not have to actually borrow the money and does not become the owner of the underlying securities within the index.
Key Learning Points
- Equity swaps are a type of derivative where the two parties agree to exchange cash flows over a period of time
- One of the cash flows in an equity swap will always be the return on an equity index
- There are four key equity swaps terminologies that one should be aware of: notional principal, payment reset/frequency period, tenor and netting
- In the equity swap example, we calculate the size and direction of payment on the first payment date for the equity swap that we are presented with
Equity Swaps Terminology
There are some key terminologies to be aware of regarding equity swaps:
Notional principal: this is determined within the Swap contract and is the amount of money that is not paid between the two counterparties but which is the basis for the calculations of the interest and equity return legs. So, if the notional principal on an equity swap trade was $100 million dollars, then you need to multiply the LIBOR rate by $100 million to get the cash flow on the interest rate leg. The return generated on the S&P 500 would need to be multiplied by the $100 million to get the cash flow on the equity return leg.
Payment frequency/reset period: this refers to how frequently within the entire lifetime of the swap these cash flows are going to be exchanged. In other words, the payment frequency/reset period refers to how frequently the return on the two legs of the swaps is paid.
Tenor: refers to the total life or tenor of the swap. So an equity swap may be a 5-year tenor swap with semi-annual payment frequency, which means that the swap’s total life is 5 years and every six months we calculate the interest payable on both the interest rate leg and the return on the equity index leg and exchange those cash flows.
Netting: this refers to the payments between two parties of the swap that are not made in total, but are netted off. In other words, as the terminology suggests, the full amount of the payment on the interest leg and the return on the S&P 500 leg is always made. However, the two payments are netted off. So if the interest rate leg has a higher dollar value than the return on equity index leg – there will be a payment of a net amount from the interest rate leg payer to the counterparty that is responsible for paying the return on the S&P 500.
Equity Swaps – Example
Given is an example below relating to equity swaps. From the information given below, we can calculate the size and direction of payment on the first payment date for the equity swap we are presented with. This example has semi-annual reset periods. The equity leg is based on the S&P 500 price return only and the interest rate leg is based on a floating interest rate of 6-month US$-LIBOR.
Now at the beginning of the first payment period, 6-month US$-LIBOR is 3%. The return generated during the first six month period on the S&P 500 is 8% in terms of price return, and in addition to that 2% dividend yield on S&P 500. The notional principal for the swap is $100 million.
The first thing that we calculate is the payment due on the equity leg, which we calculate by taking the notional principal on the swap and since this is a price return swap only, we only need to include the 8% return on the S&P 500 from a price return basis. This calculation gives $8 million.
We now need to calculate the interest payment due on the floating rate leg. To do this, we take the notional principal on the swap of a $100 million and multiply this by the 3% US$ LIBOR and we also multiply this by 0.5 for half a year.This yields $1.5 million. It may seem that there is some inconsistency between the equity leg and the interest rate leg. However, the 8% return is within the 6 month period whereas the interest rate of 3% is always quoted on an annualized basis. So to de-annualize that down to half a year’s worth of interest, we need to multiply it by 0.5.
The net payment will be the net of these two amounts i.e. $8 million payable on the equity leg and $1.5 million payable on the interest rate leg i.e. the net of these two will result in a $6.5 million payment.
It must be noted that the whole of $8 million is not paid in one direction and $1.5 million paid in the opposite direction but rather $6.5 million of cash payment is made from one side of the swap to the other. Finally, regarding the direction of the payment, this payment will be made from the interest rate receiver to the equity index receiver.