Derivatives

CHAPTER 37Equity Swaps

Aims

• To demonstrate how equity swaps allow an investor to gain temporary exposure to the stock market without actually buying or selling the stocks in her existing portfolio. The investor can then revert to her original stock portfolio at the termination of the swap.
• To describe how an ‘asset swap’ may involve a single equity, a basket of equities or a market index (e.g. S&P 500), either in the same currency or in different currencies – in the latter case the investor has to decide on whether to hedge the currency risk.
• To use arbitrage arguments to price an equity-for-LIBOR swap. Somewhat counter-intuitively receiving the return on equity and paying LIBOR is a fair swap, since the present values of the two legs are equal.
• To show how to price a domestic equity-for-domestic equity swap, or a swap of the return on a domestic equity for the return on a foreign equity.
• To demonstrate how to value an equity swap after inception of the swap. The value of an equity swap to one of the parties may be positive or negative and its value depends on the change in equity prices.

Equity swaps allow an investor to change her existing stock market risk without necessarily owning stocks or changing the amount of stocks she already holds. An equity swap is an OTC transaction which involves cash flows based on a notional principal amount. One leg of an equity swap is based on the return on a specific equity ‘portfolio’ such as a single stock, a basket of stocks or a stock ...