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An equity swap is a deal between two investors who each have a source of income from an existing investment. The deal means they agree to exchange the income they receive from these investments, either as a one-off exchange or over a set period of time. In some situations, this can serve simply as a form of wager. In other cases, one or both parties may be doing it as a form of hedging.
A swap is a type of derivative, a financial product or investment which is based upon, or "derives from," the value of another financial product. This naturally makes the arrangement more complex than a standard investment. A swap is also often used for leverage. This is where investors or financial manager use a derivative so that the money "at stake" in the investment is effectively more than the actual cash they put in.
In a swap, the two parties agree to exchange the benefits from investments they already hold. Each side uses a different investment, known as a leg; the two legs make up the deal. Normally one or both of the legs will be based on a variable income from an investment. If this was not the case, the two sides would both know how much they would make from the deal, thus meaning one of them would be guaranteed to be worse off.
In an equity swap, one leg will be based on an equity investment. In most cases this is based on the performance of a stock market. Usually the other leg will be a "floating" leg, possibly based on a particular interest rate. In that situation, the two sides would effectively be predicting how the stock market would perform in relation to interest rates. In some cases, both legs will be based on an equity investment, though of course these will be based on different equities or markets.
In many cases, an equity swap will be based around notional principal. This means the two sides do not actually have to have made the investments which the deal is based around. Instead they agree a notional, or hypothetical, investment amount. When they settle the deal, they work out how much they each would have made if they really had invested that amount. As the only money which changes hands is the difference between the "profit" on the two imaginary investments, the firms can make or lose much more than if they actually had to stump up the cash for the investment.
In some cases, an investor will enter into an equity swap simply because he believes he will make a more accurate prediction than the other side. An equity swap could also be used for hedging. This is where an investor who stands to make or lose a lot of money depending on the outcome of an investment will make a second, smaller investment which will pay off if the main investment goes badly. This minimizes both the potential profits and losses of the main investment.