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Equity swaps are agreements between two investors to trade the income they receive from existing investments, either as a one-time trade or over a set period of time. They are a type of derivative and can be used for leverage or hedging. In many cases, they are based on notional capital.
An equity swap is an agreement between two investors who have a source of income from an existing investment. The deal means that they agree to trade the income they receive from these investments, either as a one-time trade or over a set period of time. In some situations, this can simply serve as a form of betting. In other cases, one or both parties may be doing it as a form of hedging.
A swap is a type of derivative, a financial product or investment that is based on or “derives from” the value of another financial product. Naturally, this makes the deal more complex than a standard investment. An exchange is also often used for leverage. This is where investors or the financial manager use a derivative so that the money “at stake” in the investment is effectively more than the actual cash they put up.
In an exchange, the two parties agree to exchange the benefits of the investments they already own. Each side uses a different inversion, known as a leg; both legs do the deal. Typically, one or both legs will be based on a variable income from an investment. If this were not the case, both parties would know how much they would gain from the deal, which means that one of them would be worse off.
In an equity exchange, one party will be based on an equity investment. In most cases, this is based on the performance of a stock market. Typically, the other tranche will be a “floating” tranche, possibly based on a particular interest rate. In that situation, both parties would be effectively predicting how the stock market would behave relative to interest rates. In some cases, both legs will be based on an equity investment, although of course they will be based on different stocks or markets.
In many cases, a capital exchange will be based on notional capital. This means that the two parties do not have to have made the investments on which the agreement is based. Instead, they agree to a notional or hypothetical investment amount. When they work out the deal, they figure out how much each would have earned if they had actually invested that amount. Because the only money that changes hands is the difference between the “profit” of the two imaginary investments, companies stand to gain or lose much more than if they actually had to spend the investment money.
In some cases, an investor will enter a stock trade simply because they believe they will make a more accurate prediction than the other party. A stock swap could also be used for hedging. This is where an investor who stands to make or lose a lot of money depending on the outcome of one investment will make a second, smaller investment that will pay off if the main investment goes bad. This minimizes potential gains and losses on the primary investment.
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