how an equity swap works
an equity swap is similar to an interest rate swap but rather than one leg being the fixed side it is based on the return of an equity index for example one party will pay the floating leg typically linked to libor and receive the returns on a pre agreed upon index of stocks relative to the notional amount of the contract equity swaps allow parties to potentially benefit from returns of an equity security or index without the need to own shares an exchange traded fund etf or a mutual fund that tracks an index most equity swaps are conducted between large financing firms such as auto financiers investment banks and lending institutions equity swaps are typically linked to the performance of an equity security or index and include payments linked to fixed rate or floating rate securities libor rates are a common benchmark for the fixed income portion of equity swaps which tend to be held at intervals of one year or less much like commercial paper according to an announcement by the federal reserve banks should stop writing contracts using libor by the end of 2021 the intercontinental exchange the authority responsible for libor will stop publishing one week and two month libor after december 31 2021 all contracts using libor must be wrapped up by june 30 2023 1 the stream of payments in an equity swap is known as the legs one leg is the payment stream of the performance of an equity security or equity index such as the s p 500 over a specified period which is based on the specified notional value the second leg is typically based on the libor a fixed rate or another equity s or index s returns example of an equity swapassume a passively managed fund seeks to track the performance of the s p 500 the asset managers of the fund could enter into an equity swap contract so it would not have to purchase various securities that track the s p 500 the firm swaps 25 million at libor plus two basis points with an investment bank that agrees to pay any percentage increase in 25 million invested in the s p 500 index for one year therefore in one year the passively managed fund would owe the interest on 25 million based on the libor plus two basis points however its payment would be offset by 25 million multiplied by the percentage increase in the s p 500 if the s p 500 falls over the next year then the fund would have to pay the investment bank the interest payment and the percentage that the s p 500 fell multiplied by 25 million if the s p 500 rises more than libor plus two basis points the investment bank owes the passively managed fund the difference since swaps are customizable based on what two parties agree to there are many potential ways this swap could be restructured instead of libor plus two basis points we could have seen one bp or instead of the s p 500 another index could be used 