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

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Equity and Credit Default Swaps

INTRODUCTION TO EQUITY SWAPS

An equity swap is the over-the-counter answer to index and single stock futures. In a standard contract:

• two parties agree to exchange cash flows at regular intervals over an agreed period of time;

• at least one payment leg is based on the change in the value of an equity index or a specific share.

If the deal is a total return swap then the equity leg payment includes a sum of money representing dividends on the underlying shares. The return leg can be based on a fixed or a floating interest rate or on another equity index. In some structures the notional is fixed over the life of the swap and in other cases it varies. Payments are normally made monthly, quarterly, semi-annually or annually. The typical tenor (maturity) is one to three years.

Equity swaps can be more risky than interest rate swaps because the change in the value of the underlying index or stock can be negative. If this happens the party receiving the equity return has to pay its counterparty for the fall in the value of the underlying shares. Figure 7.1 shows the growth of equity forward and swap contracts. The June 2009 figure also shows how this was affected by the aftermath of the ‘credit crunch’ which started in 2007/8.

One possible 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 ...