Definition of Equity Swap

What is an equity swap? What is the definition of the term "equity swap"?

Let's say that you are a very deep-pocketed investor that is worth billions of dollars.

You would like to make a large bet on how Tesla will trade over the next year, but you don't want to buy the shares.

You call up your contact at the investment bank that you deal with, and they are only too eager to set something up for you.

What they propose is an "equity swap". Equity swaps can be as simple or as complicated as you like. Here is what your investment bank proposes for a $50 million equity swap on Tesla:

1. You agree to pay the bank an interest rate on $50 million for the year. You both decide that this amount will be 3.5%. This is the first leg of the swap.

2. You agree that the second leg of the swap will see you assume the risk (and potential reward) for $50 million worth of Tesla for the next year, based on today's closing price.

At the end of this one-year swap, the two sides will settle up.

Let's look at some possible scenarios:

1. Tesla doesn't move over the next year. This is obviously unlikely, but let's say it happens. You wouldn't make or lose anything on the Tesla shares, though you would still own the bank $1.75 million for the interest.

2. Tesla drops by 50%. A nightmare scenario for your swaps. You'd lose $25 million on the equity leg of the swap, plus another $1.75 million on the interest.

3. Tesla goes up by 100%. You'd make $50 million on the equity leg of the swap, and you'd lose $1.75 million in interest, so you'd come out ahead by $48.25 million.

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There are a few important things to consider with equity swaps:

1. They are derivative contracts, so they provide a great deal of leverage, which often gets people into trouble.

2. The rich investor entering into the swap doesn't actually own the shares of Tesla - the investment bank offering the swap owns them.

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As I said, equity swaps can be much, much more complicated than this, and usually are.

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