Equity swap
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An equity swap, a branch of derivative security, is a swap in which at least one party pays the return on a stock or stock index.
where a set of future cash flows are exchanged between two counterparties. One of these cash flow streams will typically be based on an interest bearing reference asset. The other will be based on the performance of a share of stock or stock market index. The two cash flows are usually referred to as "legs".
Examples
Thus you may Swap £5,000,000 at LIBOR + 0.03% (also called LIBOR + 3 basis points) against £5,000,000 FTSE equivalent for 6 months.
The value of the swap then is the difference, Netting, between the values of all of the payments coming in from the £5M invested at LIBOR for 6 months brought back to their present value at the time of the valuation less the value of the FTSE in 6 months time brought back to its present value. Since both of these numbers are forecasts a number of interim payments are made during the life of the swap based on a recalculation of the value of both legs or this is called a reset. The frequency of resets will be agreed by the counterparties at the start of the swap.
Applications
Typically Equity Swaps are entered into in order to avoid transaction costs (including Tax), to avoid locally based dividend taxes or to get around rules governing the particular type of investment that an institution can hold.
Investment banks that offer this product usually take a risk-neutral position by hedging the client's position with the underlying asset. For example, the client may trade a UK cash equity swap - say Vodaphone. Bank credits the client with 1000 Vodaphone at GBP1.45. The bank pays the return on this investment to the client, but also buys the stock in the same quantity for its own trading book (1000 Vodaphone at GBP1.45). Any equity-leg return paid to or due from the client is offset against realised profit or loss on its own investment in the underlying asset. The bank makes its money through commissions, interest spreads and dividend rake-off (paying the client less of the dividend than it receives itself).