A swap agreement, similar to an interest rate swap, in which one leg is pegged to the performance of a share of stock or a basket of shares, while the other leg finances this performance. As an example, consider an investor contemplating purchasing 2000 shares of XYZ company and holding the shares for one year. This swap differs from a traditional interest rate swap in the sense that the returns from an equity index may experience higher volatility than that usually typical of most floating interest rates. Also, the return on an equity index can be negative, whilst floating rates cannot fall below zero. However, equity swaps are inherently similar to traditional fixed-for-floating interest rate swaps as both involve exchanging a fixed rate for a variable rate.

If the investor buys the shares outright, for $50 a share, a capital of $100,000 would be required. To that end, the capital may come from borrowing or equity money. The first course of action would call for interest payments, while the other would incur a capital cost. Notwithstanding the means of finance, the investor’s gains which can be realized at the end of the holding period would be the share price appreciation (depreciation) plus any dividends paid over that period minus financing costs.

The investor may reduce financing costs by referring the transaction to some other party who has a cost advantage (a more competitive financing rate or a better access to the market), instead of holding the shares himself over that period. To do this, the investor may enter a swap with a third party so that the third party (the swap buyer) receives any capital appreciation and dividends on the underlying stock and pays, in return, the financing costs. In turn, the seller would be able to have the equity exposure necessary to his investments or portfolio.