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Equity Swap
An equity swap is a financial derivative contract (a swap) where a set of future
cash flows are agreed to be exchanged between two counterparties at set dates in
the future. The two cash flows are usually referred to as "legs" of the swap; one of
these "legs" is usually pegged to a floating rate such as LIBOR. This leg is also
commonly referred to as the "floating leg". The other leg of the swap is based on
the performance of either a share of stock or a stock market index. This leg is
commonly referred to as the "equity leg". Most equity swaps involve a floating leg
vs. an equity leg, although some exist with two equity legs.
Examples
Parties may agree to make periodic payments or a single payment at the maturity
of the swap ("bullet" swap).
Take a simple index swap where Party A swaps 5,000,000 at LIBOR + 0.03% (also
called LIBOR + 3 basis points) against 5,000,000 (FTSE to the 5,000,000
notional).
In this case Party A will pay (to Party B) a floating interest rate (LIBOR +0.03%) on
the 5,000,000 notional and would receive from Party B any percentage increase in
the FTSE equity index applied to the 5,000,000 notional.
In this example, assuming a LIBOR rate of 5.97% p.a. and a swap tenor of precisely
180 days, the floating leg payer/equity receiver (Party A) would owe (5.97%
+0.03%)*5,000,000*180/360 = 150,000 to the equity payer/floating leg receiver
(Party B).
At the same date (after 180 days) if the FTSE had appreciated by 10% from its level
at trade commencement, Party B would owe 10%*5,000,000 = 500,000 to Party
A. If, on the other hand, the FTSE at the six-month mark had fallen by 10% from its
level at trade commencement, Party A would owe an additional 10%*5,000,000 =
500,000 to Party B, since the flow is negative.
For mitigating credit exposure, the trade can be reset, or "marked-to-market" during
its life. In that case, appreciation or depreciation since the last reset is paid and the
notional is increased by any payment to the floating leg payer (pricing rate receiver)
or decreased by any payment from the floating leg payer (pricing rate receiver).
Equity Options
Equity options are the most common type of equity derivative. They provide the right, but not
the obligation, to buy (call) or sell (put) a quantity of stock (1 contract = 100 shares of stock), at
a set price (strike price), within a certain period of time (prior to the expiration date).
References
http://en.wikipedia.org/wiki/Equity_derivative#Equity_futures.2C_options_and_swaps
http://en.wikipedia.org/wiki/Equity_swap
John Hull Options, Futures and other derivatives Chapter's 1 and 2.