Equity Swap

Equity swaps may be a bit difficult to understand at first because to the layman it seems more like a ‘concept’ than an actual transaction. In effect, an equity swap is where two parties agree to swap assets at some future date which allows them to diversify their holdings (portfolio) in the present. This diversification adds value to their net worth while allowing each company to hold on to their assets. In other words, there is only an agreement to make the swap at a later date and nothing actually changes hands up front. Even though nothing is actually physically swapped at the time of the contractual agreement, both parties gain as though the swap transpired.

Two Legs to an Equity Swap
There are two legs to an equity swap. One is called the ‘equity leg’ while the other is called the ‘floating leg.’ The equity leg is generally attached to some asset such as stock while the floating leg is attached to floating rates such as those of LIBOR. The equity leg is associated with actual performance on the market. However, this is not always the case. Sometimes both legs are equity based. The principle will remain the same as an equity swap is agreed to. Most often these swaps are made between financial institutions, large corporations or investment banks. LIBOR rates are used as a benchmark on the leg of the swap that is fixed income.

Benefits of an Equity Swap
Perhaps the biggest benefit to an equity swap is that the holder of the shares does not actually lose possession of them at the time of making the swap. This means that he or she does not lose voting rights that are part and parcel to most shareholders yet he/she can pass on negative returns on the equity position. Also, there are times when an investor is not allowed to buy stocks in a particular company, most often due to governmental legislation such as not being a citizen of the country in which the company is registered. In this type of swap the investor will receive the return on the shares for a stipulated period of time for letting the other leg of the swap hold the shares.

Typical Reasons for Entering into Equity Swaps
Most often equity swaps provide a way to steer away from transaction costs. In fact, the largest part of the transaction cost to be concerned with is tax. They also are entered into in order to evade limitations on leverage and dividend taxes that are locally based. As mentioned above, equity swaps can also help to work around rules and laws which govern certain investments that institutions can make. And again, typically equity swaps are entered into in order to generate leverage like that seen in derivatives. Neither party to the swap loses control of assets until such time as the actual ‘swap’ takes place and that too is one of the main reasons for entering into it in the first place.

Equity swaps are not usually entered into by private investors and are typically only transacted between large investment institutions. While the individual investor may never need to be a party to an equity swap, he or she would be wise to understand how their financial institutions diversify their holdings in order to increase net worth without actual money changing hands at the time of the transaction. (Of course there are always transaction fees to take into account, but in terms of actual cash paid to either party of the swap there would be none exchanged.)

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