Equity Swaps for beginners

Before you start reading this , certain assumptions are that you must be aware of stock trading or at least the basic concepts  to it. The information here is purely for beginners.

Why equity swap?

Hedge funds , investment bankers and other corporate investors tend to invest in stock portfolios that are global and not restricted to a certain location. Due to jurisdiction norms , a certain investor may not have access to the market. It is nearly impossible for any investor to have offices domiciled in the respective countries of exchange. To fullfil trading needs in such scenarios , an equity swap is a very effective mechanism. 

Equity swaps are facilitated by prime brokers. There are many prime brokers on the street. The investors availing equity swap are mostly institutions who would be dealing in trading above a certain threshold. Usually investors have a tie up with multiple brokers.

Equity Swap basics:

An equity swap agreement is a contract where the broker would be holding the stocks or the instrument for the client. 

The equity returns on the instrument would be passed on to the client. Here the client or the counterparty bears the risk of the trade. This is known as the fixed leg or the equity leg of the payment.

As a fee for using this arrangement , the counterparty or client would be paying a certain amount (proportional to the notional) at a defined bank rate and spread. This is known as the floating leg of the payment.

Hedges:

For the prime brokers , equity swaps is a fee business as they would be hedging their counterparty trade risk against the market. For example , when a counterparty takes a long position on a stock , the broker would execute the trade for the same tax lot on the exchange. By doing so , the broker offsets its risk and is neutral to the market ups and downs.