Page 260 - A Canuck's Guide to Financial Literacy 2020

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Equity Swap

An equity swap is a derivative contract that allows two parties to exchange future cash flows
with one another. Equity swaps have two legs; an interest rate leg that is usually tied to
LIBOR and an equity leg that's tied to a return of a stock or market index. Common indices
are the Standard & Poor's 500 Index, Dow Jones Industrial Average and the New York
Stock Exchange.

For example, a hedge fund enters into a 3-year equity swap. Every three months, the hedge
fund has to pay the average of S&P 500 return in exchange of the 90-day Libor rate.

Equity swaps are popular as they allow the parties to limit transaction costs that may be
associated with equity trades. Parties are able to avoid margins and capital controls while
being able to keep their equity position without equity risk.

Commodity Swap

A commodity swap allows two parties to swap cash flows which are dependent on the price
of an underlying commodity such as gold, silver, corn, etc. Commodity swaps have a fixed
component and a variable component. One party pays a fixed commodity price while the
other pays a variable price. In comparison to futures commodity contracts, cash settlement
is the norm for commodity swaps.

The majority of commodity swaps involve oil with airlines and rail companies being the
biggest utilizers. For example, American Airline enters in a 3-year fuel oil swap because
they believe that the oil prices will be volatile in the next three years. The swap agreements
state that every three months, the airline would receive the average market price based on
a negotiated price quote and in return would pay a fixed price to the swap dealer.