TABLE OF CONTENTS There are basically two types of equity swap. The first is typically a short-term, open-ended transaction which allows users to take long or short positions in individual or pairs of shares in return for a daily marking-to-market of the contracted share(s) against a LIBOR receipt (short positions) or LIBOR payment (long positions). These instruments are known as contracts for differences (CFDs). CFDs are used by a variety of end users:
equity fund managers wishing to take positions on share price movements in a cheap, leveraged manner;
option writers wishing to maintain a delta/gamma hedged position in a cheap and effective way;
and as a cost effective way of creating a basket of stocks.
The second category refers to medium to long-term instruments that have a defined life span: it is this category that this chapter seeks to develop.
A basic equity swap would involve two parties entering into a contractual agreement to exchange a stream of cash flows linked to the total return of an equity index against a schedule of returns derived from a short-term interest rate index. Both of the cash flow streams will be transferred with an agreed frequency for a fixed period of time and will be calculated on an agreed notional principal.
The first equity swaps to be arranged were in 1989 and indicate, once again, the creativity invested in product innovation. Their initial impact on markets was mixed, and exact volumes, given the nature of...
