Equity-Linked Swap: School-To-College

imagesContinuing with our last blog, today we will discuss in detail about “Equity-Linked Swap” under Structured derivative class.

Meaning: A swap for which payments on one or both sides are linked to the performance of equities or an equity index. Sometimes used to avoid withholding taxes, obtain leverage, or enjoy the returns from ownership without actually owning equity.

Definition: An equity swap is a financial derivative contract (a swap) where a set of future cash flows are agreed to be exchanged between two counterparties at set dates in the future. The two cash flows are usually referred to as “legs” of the swap; one of these “legs” is usually pegged to a floating rate such as LIBOR. This leg is also commonly referred to as the “floating leg”. The other leg of the swap is based on the performance of either a share of stock or a stock market index. This leg is commonly referred to as the “equity leg”. Most equity swaps involve a floating leg vs. an equity leg, although some exist with two equity legs.

Features: An equity swap involves a notional principal, a specified tenor and predetermined payment intervals. Equity swaps are typically traded by Delta One trading desks. An Equity-Linked Swap is a swap agreement, similar to an interest rate swap, in which one leg is pegged to the performance of a share of stock or a basket of shares, while the other leg finances this performance. This swap differs from a traditional interest rate swap in the sense that:

  1. The returns from an equity index may experience higher volatility than that usually typical of most floating interest rates. And,
  2. The return on an equity index can be negative, whilst floating rates cannot fall below zero.

In Equity-Linked Swap, The investor may reduce financing costs by referring the transaction to some other party who has a cost advantage, instead of holding the shares himself over that period. To do this, the investor may enter a swap with a third-party so that the third-party (the swap buyer) receives any capital appreciation and dividends on the underlying stock and pays, in return, the financing costs. In turn, the seller would be able to have the equity exposure necessary to his investments or portfolio.

Uses Of Equity-Linked Swap:

  1. To take an advantage of overall price movements in a specific country’s stock market without having to purchase the equity securities directly, reducing both the transaction costs and tracking error associated with actually assembling a portfolio that mimics the index.
  2. To create a direct equity investment in a foreign country.
  3. To accumulate foreign index returns denominated in their domestic currencies.

Advantages Of Equity-Linked Swap:

  • Helps to avoid transaction costs (including Tax),
  • Helps to avoid locally based dividend taxes, limitations on leverage (notably the US margin regime),
  • Helps to get around rules governing the particular type of investment that an institution can hold.

Advantage Over Plain Vanilla Equity Investing:

  • An investor in a physical holding of shares loses possession on the shares once he sells his position. However, using an equity swap the investor can pass on the negative returns on equity position without losing the possession of the shares and hence voting rights.
  • It allows an investor to receive the return on a security which is listed in such a market where he cannot invest due to legal issues.
  • Investment banks that offer this product usually take a riskless position by hedging the client’s position with the underlying asset.

Conclusion: An equity swap which entails the exchange of cash flows based on two different rates: a floating rate (e.g., 3-month LIBOR) and the return on an equity index. This swap can be based on the total return on the percentage change in a benchmark index for the settlement period in addition to a fixed spread adjustment. The equity index-linked swap is equivalent to a set of successive forward contracts which call for the exchange of the above two streams of cash flow. Equity swaps, if effectively used, can make investment barriers vanish and help an investor create leverage similar to those seen in derivative products.

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