An equity swap is an agreement between two counterparties to exchange the returns on an equity asset, such as an equity index, a custom equity basket, or a single stock exchanging that for an interest rate. This interest rate is typically based on benchmarks like SOFR, SONIA, or ESRT adjusted with a spread.
The two counterparties are referred to as the equity payer and the equity receiver. The equity receiver receives the total returns on the underlying equity asset, which includes both price appreciation and dividends. This mimics the economics of being long the equity as the receiver benefits from market gains and dividend income.
The equity payer receives a floating interest rate based on a reference rate, e.g. SOFR or SONIA plus a spread from the equity receiver. But also, if the underlying equity falls in value, they will receive that from the equity receiver.
Let's look at a simple example. If the underlying equity index increases by 5% over a year and pays a 2% dividend yield, the equity receiver would receive a total return of 7% minus the floating rate paid to the equity payer. This floating rate compensates the equity payer for the cost of financing the position, which typically reflects the benchmark rate plus a spread. Equity swaps allow investors to gain or hedge equity market exposure without directly owning the underlying assets. They also introduce leverage as the investor only needs to post a margin, which is typically a fraction of the notional amount. To understand how equity swaps work in practice, let's break down the key factors that define these agreements.
Notional amount, in equity swaps the notional amount is the agreed upon value used to calculate payments on both legs of the transaction. This amount does not physically exchange hands, but serves as the basis for calculating the cash flows.
Tenor. The tenor or duration of the swap is often set at 12 months, but equity swaps usually allow either party to terminate the agreement early, making the structure more flexible. Return type. Most equity swaps are structured as total return swaps, meaning they include both price movements and dividends of the underlying equity. While price return swaps, which exclude dividends, while they are possible, they are rarely used. Reference rates and spread. The floating interest rate paid by the equity receiver is based on a benchmark rate such as SOFR or SONIA, with an added spread reflecting market conditions and credit risk.
Reset Frequency. Payments between the parties are exchanged periodically, typically monthly or quarterly based on the performance of the underlying equity and the accumulated interest rate obligations. This periodic reset ensures that the swap adapts to market fluctuations and minimizes counterpart exposure.
Margin. While equity swaps typically are not centrally cleared, bilateral margining between the two counterparties is required, including initial and variation margining. Margin requirements may be static or dynamically adjusted when the notional amount changes due to movements in the underlying equity value, the initial margin may be recalculated.
This dynamic adjustment benefits both parties by reducing counterparty risk, ensuring that the collateral reflects the current market exposure. For example, if the underlying equity value rises, the margin requirement increases to account for the larger potential liability.
