A swap is where two counterparties enter into a derivative contract where they are agreeing to exchange cash flows over a period of time. An equity swap is where one of those cash flows being exchanged is the return on an equity index. In this example, you can see that the client is paying interest LIBOR, whereas the bank is agreeing to pay the return on the S&P500 equity index. The outcome of this swap is that the client is in the position of having effectively borrowed money to invest in the securities of the S&P500 index. Had they done that, they would have to pay interest on the money that they borrowed and they would be earning the return on the S&P500 index. However, with the swap the client doesn't have to actually borrow the money and doesn't become the owner of the underlying securities within the index. Some key terminology to be aware of with regards to equity swaps. Firstly, the notional principle. This is determined within the swap contract and is an amount of money which is not paid between the two counterparties, but which is the basis for the calculations of the interest and equity return legs.

So if the notional principle on an equity swap trade was $100 million, then you'd need to multiply the LIBOR rate by the 100 million to get the cash flow on the interest rate leg, and the return generated on the S&P500 would need to be multiplied by the $100 million to get the cash flow on the equity return leg.

Next, the payment frequency or reset period refers to how frequently within the entire life of the swap these cash flows are going to be exchanged on the two legs of the swap. And the second time period that we're gonna have to define within the swap agreement is the swap's tenor or its total life. So our equity swap may be a five-year tenor swap with semi-annual payment frequency, which means that the swap's total life is five years and every six months we calculate the interest payable on the interest rate leg and the return on the equity index leg and exchange those cash flows. However, as the final bit of terminology here suggests the full amount of the payment on the interest leg and the return on the S&P500 leg are not always made. However, the two payments are netted off. So if the interest leg was a higher dollar value than the return on the equity index leg there would be a payment of the net amount from the interest rate leg payer to the counterparty that is responsible for paying the return on the S&P500.