The valuation of equity swaps may, at first sight, seem more complex than the pricing of interest rate swaps because the total return to the index is not known at the outset. However, as the equity index is a carryable asset, it is possible to develop an arbitrage-free value of the equity side of the swap in a manner analogous to the pricing a long-term futures contract.

For example, if a party were to pay the equity returns, it is effectively going short the equity market. This position could be hedged by buying the underlying index with the proceeds of a floating rate loan. The interest costs of the loan will be serviced from the LIBOR receipts under the swap. The liability to pay the equity returns under the swap will be serviced by the dividends and capital appreciation of the index fund. The result is that the net value of the index portfolio is always the original cost of purchasing that fund. Thus the equity side is always valued as the initial cost of buying the index.

In order to understand this, consider the position of the party paying the equity returns and receiving floating when the index shows a negative total return. The value of the index fund will fall from its original level, but the pay equity side receives LIBOR, plus the negative return to the index from the pay LIBOR side. The LIBOR payment services the loan, and the receipt, equal to the negative return to the index, is reinvested in the index in order to maintain the value of the equity portfolio.

The floating rate side is valued in the same manner as in a fixed for floating interest rate swap: for example, by assuming that the value of the underlying floating rate asset will be par at the next interest rate reset date, and calculating the present value of the next floating payment and par value.

As the value of the equity swap is the difference between the original value of the notional index fund and the present value of the floating rate instrument, its secondary market value is likely to be relatively stable. The reason is that the value of the equity side is constant at the original cost and the floating rate side is assumed to be valued at par on each reset date, that par value being equal to the original cost of the notional index fund. This relative stability in price may limit the development of the secondary market in these swaps. It is therefore likely that any secondary market transactions result from end-users wishing to change the distribution of their expected returns rather than from revisions to their level of expected returns.

Investment banks have been on one side of most of the equity swaps transacted and they tend to hedge their position via the traded equity index futures market. Thus the cash flow dates tend to be related to the maturity of the equity index futures contracts. This enables the cash flows from the margin payments under the futures contract to contribute to the cash flow under the swap.

Credit risk will be an important consideration with equity swaps because the investors are not just buying equity market risk, but also counterparty risk. Although the exposure to this risk will be limited to the differences in the contracted cash flows, it still has to be taken into account.

In addition, the investment in the LIBOR instrument for those wishing to receive equity will entail a credit risk in the LIBOR instrument. However, for those investors that can tolerate the credit risk of investing in an instrument paying LIBOR, plus a spread, paying only LIBOR under the swap will help the investor outperform the index. Indeed using some of the asset-backed securities paying large spreads over LIBOR will enhance the out performance of the index; nevertheless this is not a ‘free lunch’. The investor is really taking on additional credit risk in order to achieve a return in excess of that rewarded for bearing just equity market risk.

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