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An equity swap is a derivative security where a set of future cash flows are exchanged between two counterparties. One of these cash flow streams will typically be based on an interest bearing reference asset. The other will be based on the performance of a share of stock or stock market index. The two cash flows are usually referred to as "legs". Thus you may Swap £5,000,000 at LIBOR + 0.03% (also called LIBOR + 3 basis points) against £5,000,000 FTSE equivalent for 6 months.
The value of the swap then is the difference between the values of all of the payments coming in from the £5M invested at LIBOR for 6 months brought back to their present value at the time of the valuation less the value of the FTSE in 6 months time brought back to its present value. Since both of these numbers are forecasts a number of interim payments are made during the life of the swap based on a recalculation of the value of both legs or this is called a reset. The frequency of resets will be agreed by the counterparties at the start of the swap.
Typically Equity Swaps are entered into in order to avoid transaction costs (including Tax), to avoid locally based dividend taxes or to get around rules governing the particular type of investment that an institution can hold.
See also
Derivatives
