Equity Derivative

Equity Swap
An equity swap is a financial derivative contract (a swap) where a set of future
cash flows are agreed to be exchanged between two counterparties at set dates in
the future. The two cash flows are usually referred to as "legs" of the swap; one of
these "legs" is usually pegged to a floating rate such as LIBOR. This leg is also
commonly referred to as the "floating leg". The other leg of the swap is based on
the performance of either a share of stock or a stock market index. This leg is
commonly referred to as the "equity leg". Most equity swaps involve a floating leg
vs. an equity leg, although some exist with two equity legs.
Examples
Parties may agree to make periodic payments or a single payment at the maturity
of the swap ("bullet" swap).
Take a simple index swap where Party A swaps 5,000,000 at LIBOR + 0.03% (also
called LIBOR + 3 basis points) against 5,000,000 (FTSE to the 5,000,000
notional).
In this case Party A will pay (to Party B) a floating interest rate (LIBOR +0.03%) on
the 5,000,000 notional and would receive from Party B any percentage increase in
the FTSE equity index applied to the 5,000,000 notional.
In this example, assuming a LIBOR rate of 5.97% p.a. and a swap tenor of precisely
180 days, the floating leg payer/equity receiver (Party A) would owe (5.97%
+0.03%)*5,000,000*180/360 = 150,000 to the equity payer/floating leg receiver
(Party B).
At the same date (after 180 days) if the FTSE had appreciated by 10% from its level
at trade commencement, Party B would owe 10%*5,000,000 = 500,000 to Party
A. If, on the other hand, the FTSE at the six-month mark had fallen by 10% from its
level at trade commencement, Party A would owe an additional 10%*5,000,000 =
500,000 to Party B, since the flow is negative.
For mitigating credit exposure, the trade can be reset, or "marked-to-market" during
its life. In that case, appreciation or depreciation since the last reset is paid and the
notional is increased by any payment to the floating leg payer (pricing rate receiver)
or decreased by any payment from the floating leg payer (pricing rate receiver).

Application and benefits

Typically equity swaps are entered into in order to avoid transaction costs (including
Tax), to avoid locally based dividend taxes, limitations on leverage (notably the US
margin regime) or to get around rules governing the particular type of investment
that an institution can hold.
Equity swaps also provide the following benefits over plain vanilla equity investing:
1. An investor in a physical holding of shares loses possession on the shares once
he sells his position. However, using an equity swap the investor can pass on the
negative returns on equity position without losing the possession of the shares and
hence voting rights. For example, let's say A holds 100 shares of a Petroleum
Company. As the price of crude falls the investor believes the stock would start
giving him negative returns in the short run. However, his holding gives him a
strategic voting right in the board which he does not want to lose. Hence, he enters
into an equity swap deal wherein he agrees to pay Party B the return on his shares
against LIBOR+25bps on a notional amt. If A is proven right, he will get money from
B on account of the negative return on the stock as well as LIBOR+25bps on the
notional. Hence, he mitigates the negative returns on the stock without losing on
voting rights.
2. It allows an investor to receive the return on a security which is listed in such a
market where he cannot invest due to legal issues. For example, let's say A wants to
invest in company X listed in Country C. However, A is not allowed to invest in
Country C due to capital control regulations. He can however, enter into a contract
with B, who is a resident of C, and ask him to buy the shares of company X and
provide him with the return on share X and he agrees to pay him a fixed / floating
rate of return.
Equity swaps, if effectively used, can make investment barriers vanish and help an
investor create leverage similar to those seen in derivative products.
Investment banks that offer this product usually take a riskless position by hedging
the client's position with the underlying asset. For example, the client may trade a
swap - say Vodafone. The bank credits the client with 1,000 Vodafone at GBP1.45.
The bank pays the return on this investment to the client, but also buys the stock in
the same quantity for its own trading book (1,000 Vodafone at GBP1.45). Any
equity-leg return paid to or due from the client is offset against realised profit or loss
on its own investment in the underlying asset. The bank makes its money through
commissions, interest spreads and dividend rake-off (paying the client less of the
dividend than it receives itself). It may also use the hedge position stock (1,000
Vodafone in this example) as part of a funding transaction such as stock
lending,repo or as collateral for a loan.

Stock market index futures

Stock markets index futures are futures contracts used to replicate the performance
of an underlying stock market index. They can be used for hedging against an
existing equity position, or speculating on future movements of the index. Indices
for futures include well-established indices such as S&P, FTSE, DAX, CAC40,S&P CNX
Nifty. Indices for OTC products are broadly similar, but offer more flexibility
Single-stock futures
Single-stock futures are exchange-traded futures contracts based on an individual
underlying security rather than a stock index. Their performance is similar to that of
the underlying equity itself, although as futures contracts they are usually traded
with greater leverage. Another difference is that holders of long positions in single
stock futures typically do not receive dividends and holders of short positions do not
pay dividends. Single-stock futures may be cash-settled or physically settled by the
transfer of the underlying stocks at expiration.

Equity Options
Equity options are the most common type of equity derivative. They provide the right, but not
the obligation, to buy (call) or sell (put) a quantity of stock (1 contract = 100 shares of stock), at
a set price (strike price), within a certain period of time (prior to the expiration date).
References
http://en.wikipedia.org/wiki/Equity_derivative#Equity_futures.2C_options_and_swaps
http://en.wikipedia.org/wiki/Equity_swap
John Hull Options, Futures and other derivatives Chapter's 1 and 2.