The Practical Guide to Wall Street: Equities and Derivatives

CHAPTER 8

Swaps

INTRODUCTION

Within equity derivatives, equity swaps has been an area of considerable growth in recent years, with many firms setting up new swaps trading desks or expanding their existing businesses. Surprisingly, while other recent areas of growth on Wall Street—such as credit, energy, and weather derivatives—involve esoteric structures that require sophisticated mathematical models for valuation and risk management, an equity swap is perhaps the simplest equity derivative available. Stranger still is the fact that, despite being such a simple product, it is also one of the more widely misunderstood. The reasons for this are many but generally center on the fact that, unlike other equity products, whose appeal for clients is readily apparent from their structure, an equity swap is so simple that it is not immediately apparent what benefit there would be for a client in using one. As we will see, the appeal of swaps is not in the structure itself but in the applications of that structure, some of which are quite obvious while others can only be properly appreciated by those with a more detailed understanding of finance.

Because it is such a flexible tool with so many different applications, a general definition of an equity swap is so broad as to be almost useless. We therefore take a different approach to this chapter and focus first on a particular use of an equity swap in order to clearly establish why an investor would use a swap in the first place. This, ...