An equity swap is conducted by two parties with the intent usually being to save costs on a transaction. These costs may be in the form of basic taxes, or other costs associated with the transaction such as locally based dividend taxes. Another reason for companies, specifically those in the US, to engage in equity swaps is to increase the amount of market leverage a trader can exert, which essentially means bending the rules on margin requirements so that the trader can purchase more of the equity on margin. By conducting an equity swap, some portion of the total amount of the equity is paid for now and the rest, at a set future date. The contract spells out the terms of the transaction, and each party’s future cash flow is commonly referred to as a “leg”.
In most cases, one party to the equity swap transaction is the trading company and the other is an investment bank, with the trader initiating the contract. The trader hopes to profit by the investment made possible by the equity swap, while the bank makes a quantified profit on commission fees and any favorable spread in interest rates.
Another way to detail an equity swap is to posit this example: a trader and an investment bank contract to make an “equity swap” with a specific future date where actual money will change hands. The investment bank will provide the funds to purchase an equity instrument perhaps a stock or shares in an exchange traded fund.
For the trader, the optimum outcome is that the shares will rise to at least a level that allows the reimbursement of the invested funds to the bank, plus accumulated interest. Equity swaps are just one type of Derivative investment, a class of financial instruments that also includes Interest Rate Swaps, Total Return Swaps, Option Swaps and other so-called “Contracts for Difference”.