Equity swaps – introduction
An equity swap is an arrangement in which one party buys stock on behalf of another and receives interest from the other party, with the two parties periodically settling up paper gains/losses on the stock.
Equity swaps are a popular way to circumvent local restrictions on the purchase of stock by foreigners. The periodic settlement feature substantially reduces the credit risk involved.
Equity Swap Example
A U.K. customer (firm A) could enter into an arrangement with another firm (B) that has the ability to buy Japanese shares. This swap might involve B buying shares for a set period of time on A’s behalf, with B borrowing the money to acquire them. Firm A would pay LIBOR plus a spread to B to cover the borrowing costs. Every 3 or 6 months there would be a periodic settlement, with B paying A if the stock went up, or A paying B if the stock went down. The payment between the two parties might simply be the gain or loss on the stock or it could involve a payment in respect of income received too.