One of the tools in the arsenal of asset management firms is the equity swap. Rather than directly investing in equities — that is, buying stocks of publicly traded companies — the equity swap provides "synthetic" exposure to the return generated by these same stocks through contractual arrangements with third parties. Equity swaps come in different flavors, including the bullet swap. Bullet swaps are settled at the end of a contract with a single payment.
Mechanics of an Equity Swap
In finance, a swap is an agreement between two parties to exchange one set of cash flows for another over a predetermined period of time. An equity swap indicates that one of the cash flows references the returns of a stock or group of stocks. This element is the "equity leg." The other cash flow in the swap references a benchmark, such as the London Interbank Offered Rate, the interest rate that major banks in London charge each other. This benchmark is sometimes called the "floating leg" because its value fluctuates daily.
Tracing a Bullet Swap
Suppose Party A enters into a one-year equity swap with Party B to receive the return of the S&P 500 in exchange for LIBOR + 0.75 percent. Assume the S&P 500 rises by 7 percent over the course of one year and that LIBOR is 5 percent. Party A made a good trade and pockets the difference between the return of the equity leg, or 10 percent, and the return of the floating leg, or 5.75 percent. In a bullet swap, Party A gets a net return of 4.25 percent when the contract ends.
Advantages of Reset Swaps
The reset swap, another type of equity swap, works differently from a bullet swap in that the gains and losses for both parties are reflected in the swap value throughout its life. This is also known as "mark to market." Many equity swaps are structured as reset swaps to mitigate credit risk, or the possibility the party that owes money can't meet its obligations. A reset swap can mitigate concerns when one of the parties doesn't have a strong track record, such as a low credit rating.
Making it Work
One common application of any equity swap is index funds, which offer investors the return on a basket of stocks, such as the S&P 500. Rather than buying the individual stocks in an index and rebalancing the portfolio as its companies change, asset management firms can enter into an equity swap and save themselves the administrative and transaction costs. Another application involves buying small-cap or emerging market equities. Instead of buying thinly-traded stocks for which there may not be sellers or dealing with international investment regulations, asset management firms can enter into an equity swap and achieve the same effect.