Equity swaps are derivative contracts that allow two parties to trade equity exposure in a way that suits their needs.
The most common type of equity swap is the equity total return swap, which allows one party to receive the total return from an equity index or basket of stocks, while the other party pays a stream of payments based on a fixed rate or another floating rate.
Equity swaps can be used for a variety of purposes, including hedging equity risk, accessing hard-to-reach markets, and taking positions without actually owning the underlying equity.
If you’re interested in trading equity swaps, it’s important to understand the basics of how they work and the risks involved.
Below is a quick overview.
How Equity Swaps Work
In a typical equity swap, one party agrees to pay the other party a stream of payments based on the performance of an equity index or basket of stocks.
In exchange, the other party pays a fixed rate or another floating rate. The two parties can agree to swap payments at regular intervals, or they can choose to settle up at the end of the contract period.
The equity that’s used as collateral in an equity swap can be shares of stock, an equity index (such as the S&P 500), or a basket of stocks.
The baskets are usually made up of stocks from the same sector or region, which helps to minimize risk.
Why Use Equity Swaps?
As mentioned, equity swaps can be used for various reasons. For example, they can be used to:
- hedge unwanted equity exposure
- access markets for which other options are not readily available (e.g., can’t locate shares, poor liquidity, can’t access markets directly)
- take positions without have to own shares
- avoid disclosure requirements (e.g., report long positions in cash equities, such as what has to be filed as part of a 13-F)
- lower one’s collateral requirements
Hedging equity risk is one of the most popular uses for equity swaps.
By swapping equity exposure for a fixed rate or another floating rate, investors can protect themselves from potential losses if the equity market declines.
Another popular use for equity swaps is accessing hard-to-reach markets.
For example, let’s say an investor wants to invest in a foreign stock market but doesn’t want to deal with the hassle of opening a foreign brokerage account.
The investor could enter into an equity swap with a counterparty who has access to that market.
Equity swaps can be used to take positions without actually owning the underlying equity.
This can be useful for investors who want to avoid the fees and commissions associated with buying and selling stocks.
They also have other benefits. Derivative positions may allow traders and investors to circumvent any disclosure requirements.
Equity swaps can also usually provide exposures with less collateral than owning the underlying shares.
What Are the Risks?
Equity swaps are complex financial instruments, so it’s important to understand the risks before entering into any type of contract.
One of the biggest risks is counterparty risk. This is the risk that one of the parties involved in the swap will default on their payments.
To mitigate this risk, it’s important to choose a counterparty who is financially sound and has a good reputation.
Big investment banks usually transact in swaps. Many have bankers dedicated to this purpose. They’ll hedge this exposure in various ways.
Another risk to consider is market risk. This is the risk that the equity market will move against your position.
For example, if you enter into an equity swap that gives you exposure to the S&P 500, you could lose money if the index declines.
Swaps also enable more highly leveraged positions, so this can be a risk if prices go against a trader.
Bill Hwang’s Archegos Family Office got into trouble using concentrated positions in swap positions.
Finally, there’s the risk of equity price volatility. This is the risk that the price of the underlying equity will fluctuate wildly, which can make it difficult to value the equity swap contract.
Before entering into an equity swap, be sure to understand all of the risks involved. Choose a counterparty who is financially sound and has a good reputation. And always be aware of market risk and equity price volatility.
Equity swaps are complex financial instruments that can be used for a variety of purposes, including hedging equity risk, accessing hard-to-reach markets, and taking positions without actually owning the underlying equity.
Before entering into an equity swap, be sure to understand all of the risks involved.
Counterparties need to be chosen wisely and anyone involved in swaps needs to understand their market risk and the price volatility they’re exposed to.