An equity swap is an agreement to exchange cash flows tied to the return on a stock market index in exchange for a fixed or floating rate of interest. An example is a swap that provides the return on the S&P 500 index every six months in exchange for payment of LIBOR plus a spread. The swap will be typically priced so as to have zero value at initiation.
These swaps are used by investment managers to acquire exposure to, for example, an emerging market, without having to invest in the market itself.
A contract in which one party pays a fixed rate of interest on a notional amount in return for the return on a single stock, paid quarterly for four quarters, is a(n):
A. returns swap.
B. equity swap.
C. plain vanilla swap.
The answer is B.
A swap contract in which at least one party makes payments based on the return on an equity, portfolio, or market index, is called an equity swap.
Consider a 1-year quarterly-pay \$1,000,000 equity swap based on a fixed rate and an index return. The current fixed rate is 3.0 percent and the index is at 840. At the first settlement dates on the swap, the index level is 881. The equity-return payer in the swap will pay:
The equity-return payer will pay the index return minus the fixed rate at the initiation of the swap.
[(881/840 – 1) – 0.0075] × 1,000,000 = $41,309.52