An equity swap exchanges the total return on an equity index or a single stock for something else. Three forms cover the market.
In a return-for-fixed swap one party pays a fixed rate on the notional and receives the index's total return. That is the synthetic long, and the equity receiver has the economics of owning the index, funded at the fixed rate, without holding a share.
Move the funding leg to a floating reference rate and the same trade becomes return-for-floating, which is the more common institutional form, because the funding leg then matches the way the dealer actually finances the hedge.
Both legs can instead be equity returns, on different indices or different stocks, which makes the trade a return-for-return. That is how a manager expresses a relative view, or how an allocation is shifted between two markets without selling anything in either.
How is an equity swap valued?
The valuation is the same in every form, and it is easier than it looks once you see the two objects.
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The equity leg is worth the notional grown by the index return since the last reset: N × (I_t / I_reset). At a reset the leg is worth exactly the notional, which is the equity analogue of a floating-rate note pricing at par on a coupon date.
The funding leg is a bond. For return-for-fixed it is a fixed-rate bond with the swap's rate, the swap's remaining coupon dates and face equal to the notional. For return-for-floating it is a floating-rate note, worth par at a reset and worth the next coupon plus par discounted at any other time.
The swap's value to the equity receiver is the difference. In Worked example 6 a ₹50 crore one-year quarterly swap receiving the Nifty 50 total return and paying 7.20% fixed, valued 45 days into the first quarter after the index rose 2.500000%, has an equity leg of ₹51.250000 crore, a fixed leg of ₹50.601867 crore, and a value of ₹64.81 lakh to the receiver, or 1.296266% of notional.
Read the decomposition rather than the total. The index contributed ₹1.25 crore. The fixed leg is worth ₹60.19 lakh more than par, because the swap locked a 7.20% coupon on a curve now trading below it and because a nearly full quarter's coupon is still owed. Net, the receiver is up ₹64.81 lakh. The breakeven index level that would make the swap worth zero today is 25,098.53, a 1.203734% rise from the reset. Below that the equity receiver is losing even though the index is up, and that gap is the funding cost made visible.
What is an equity swap used for?
Two uses justify the instrument.
The first is synthetic exposure without the cash market. A pension trust that wants Indian equity exposure but cannot or does not want to buy and custody a basket rents it through a swap, paying a funding rate and receiving the total return. Access constraints, custody cost, dividend withholding and the operational load of a rebalance all argue for the swap; the counterparty exposure and the funding spread argue against it. DV1.05 owns the futures route to the same exposure and the comparison between the two.
The second is concentration without a sale. A holder of a large single position can pay the stock's total return and receive an index return, converting a concentrated exposure into a diversified one without disposing of the shares. That is a real structure with real uses, and it is also the structure that concentrated derivative positions have repeatedly been built out of, so the counterparty's ability to hedge it is part of the risk. The tax treatment of such a structure is jurisdiction-specific and is not a derivatives question.