A swap in which at least one party’s payments are based on the rate of return of an equity index, such as the S&P 500. The other party’s payments can be based on a fixed rate, a non-equity variable rate, or even a different equity index. Equity swaps provide an easy and inexpensive means of reallocating a portfolio to a different equity sector.
There are many ways to structure an equity swap. For example, the notional principal can be fixed or variable. A fixed notional principal would replicate the position of a portfolio that is rebalanced periodically to maintain the same dollar allocation to a particular asset class. A variable notional principal would reflect a portfolio that is not rebalanced, but whose allocations grow or recede due to changes in the relative market values of its asset classes. In addition, an equity swap can be set up so that one either absorbs or is hedged against the currency risk, depending upon the base currency used for the notational principal. Equity swaps can also be concentrated on specific industries, market sectors, or even individual stocks, though the latter is not common.
Equity swaps do have a potentially greater downside risk than interest rate swaps, since equity returns, unlike interest rates, can be negative. Thus, if one market used in an equity swap goes down while the other goes up, the responsibility for both sides of the payments could fall on just one of the parties.
See also: Interest Rate Swap