Equity Swap
Also known as: Price return swap
Trade the return of a stock or index against an interest rate — exposure without ownership.
1 · SnapshotThe one idea to remember
2 · BeginnerWhat is it, really?
An equity swap is an agreement to exchange two streams of payments: one side pays the return of a stock or index, the other pays an interest rate (usually a floating money-market rate plus a spread) on the same notional amount.
Receive the equity leg and you profit when the stock rises and pay when it falls — exactly as if you owned it, though you never touch a share. The other side, typically a bank, holds the actual shares as its hedge and effectively lends you the exposure.
Why bother? Ownership can be expensive or impossible: foreign-investor restrictions, tax frictions, disclosure thresholds, or simply not wanting to tie up cash. A swap converts all of that into a clean financing arrangement.
- Asset class
- Equity derivatives
- Instrument type
- Swap (linear)
- Traded
- OTC, bilateral
- Typical users
- Hedge funds, banks, asset managers
3 · IntermediateHow it works in practice
Anatomy of a trade
- Notional: e.g. €10M of an index. Often "resetting" — the notional is marked to the index each period.
- Equity leg: price return (capital gains only) or total return (including dividends — see Total Return Swap).
- Financing leg: floating rate (€STR, SOFR) ± spread. The spread is the bank's charge for balance sheet, hedging costs and stock borrow.
- Resets: at each period-end, the equity performance is cash-settled and the clock restarts.
Who pays whom
If the index returned +3% this quarter and financing is 1% for the period, the equity receiver nets +2% × notional. If the index fell 4%, they pay 5% × notional (4% loss plus 1% financing).
Common motivations
- Synthetic prime brokerage: hedge funds run long/short books largely via swaps ("delta one").
- Market access: exposure to markets where direct custody is impractical.
- Dividend and tax positioning — heavily regulated; the era of cross-border dividend-tax swaps has driven major rule changes.
4 · AdvancedPricing & valuation
Valuation
A resetting equity swap is worth zero at each reset with a fair financing spread; between resets, its value is the accrued equity performance minus accrued financing, discounted:
What the symbols mean
- Va value
- ta point in time
- Nthe normal distribution, or a count
- Sthe price of the underlying today
- rthe interest rate, per year
- tautime remaining, in years
The full swap is a strip of forward-starting periods, each valued off the equity forward curve \(F(T)\) and the discount curve. Because each period's exposure resets, duration is short and the trade is dominated by the spread \(s\).
What sets the spread
What the symbols mean
- cthe coupon rate
- deltaa small change in whatever follows
- pia probability, or a profit, depending on the line above
Long exposure a bank can hedge with easily-funded index futures commands tight spreads; hard-to-borrow single names on the short side can cost hundreds of basis points.
Risk management view
Delta is ~1 by construction; residual risks are dividends (if price-return), rate resets, correlation between client default and equity level (wrong-way risk), and gap risk on resets. Since 2021's family-office blowups, swap desks stress concentrated single-name books far harder.
The formulas above are standard textbook formulations, simplified for teaching. They explain the mechanism — they are not a valuation tool, and they will not reproduce a dealer’s price.
5 · Desk notesHow practitioners think about it
Where this instrument shows up elsewhere
- HedgingSome background helpsConceptsA hedge does not remove risk