Derivatives Demystified: A Step-by-Step Guide to Forwards, Futures, Swaps and Options

Chapter 7. Equity and Credit Default Swaps

EQUITY SWAPS

An equity swap is the over-the-counter alternative to equity index and single stock futures. It is an agreement between two parties:

• to exchange payments at regular intervals;

• over an agreed period of time;

• where at least one of the payment legs depends on the value of a share, a basket of shares or a stockmarket index.

In a total return deal a payment is also made which reflects the dividends on the share or basket or index. A typical equity swap application occurs when a company owns a block of shares in another firm (this is sometimes known as a corporate cross-holding) which it would like to 'monetize', i.e. to sell for cash. However, the company wishes to retain the economic exposure to changes in the value of the shares for some time period. The company sells the shares and enters into an equity swap in which it receives the return on the shares paid in cash on a periodic basis.

MONETIZING CORPORATE CROSS-HOLDINGS

To illustrate the idea, suppose that a company owns a block of 100 million shares in another firm. The shares are worth €1 each, with a total value of €100 million. It sells the shares to a bank and at the same time enters into a one-year equity swap. The notional principal is set at the outset at €100 million, although this will be reset later depending on what happens to the value of the shares. In the swap the bank pays the company the total return on the block of shares (capital gains or losses plus dividends) ...