The business industry in general has many different key terms that require understanding. People who want to penetrate deeper in the industry would want to learn of them. In this article, we will highlight the definition of an equity swap and basic terminologies around it.
What is a Swap?
In general terms, a swap is a derivative contract wherein the contract’s value is reliant on its represented assets. These so called assets are known as “underlying assets” and their value is typically prone to change. Thus, the derivative’s value also changes in tandem.
When two parties initiate an exchange of financial instruments, the term used is “financial swap.” Financial instruments are tradable monetary assets like cash, the contractual right to obtain cash, or proof of ownership on an asset.
Two parties engaging in a swap can base on derivatives, stocks and bonds, interest rates and cash flows. One should note that it is not the assets that are exchanged but the cash flows.
Kinds of Swaps
There are countless types of swap. We will highlight the most common types, including the equity swap.
Interest Rate Swap
The interest rate swap is the most common type. This type of swap is either a way to hedge risk or earn more money through speculation. The nature depends on where the parties involve stand financially. It is generally used by entities who are in need of finances. It is also useful for those who want to secure their present status against fluctuations in interest rates.
This type of swap involves companies who wish to acquire relatively low interest rates on foreign currency. In a currency swap, the principal and interest rates of a loan in a particular currency are exchanged with that of another currency.
A commodity swap is dependent on an underlying commodity’s value. This type of swap is popular in the oil industry.
Entities offer equity rather than cash to debt holders in this kind of swap. The strategy is useful when a company experiences difficulty in paying debt holders. It also helps finance projects.
Finally, we will discuss the equity swap. Here, two parties exchange two cash flows. One party will represent the returns on a stock or stock index while the other represents cash flow from a floating money market index or a fixed rate. The parties can also conduct an equity swap when the two cash flows are from a stock or stock index.