Question

How does a cross-currency swap hedge the equity stake?

Answer 1

A financial swap is an Over the Counter (OTC) derivative contract which involves an exchange of stream of cash flows.There are various types of financial swaps –

1. Plain Vanilla Interest Rate Swap - This involves swapping fixed versus floating payments based on notional principal with netting features.
2. Foreign Currency Swap – This involves swapping payments in two different currencies to bet on exchange rate movement and there is no netting features.
3. Equity Swap – This involves swapping equity returns against fixed or floating returns based on a notional principal with netting features.

Let us understand cross-currency swap hedge in equity stake through an example :

Suppose A & B enter into a foreign currency swap at a time when €1 = $2. A is expecting Euro to appreciate while B thinks otherwise. So A makes a loan of €100,000 to B @10% per annum for 5 years. B makes a loan of 100,000 x 2 ie $200,000 to A at 10% per annum for 5 years. Thus the sequence of events will be as follows –

Step 1 – Exchange of Principal

A gives €100,000 to B and B gives $200,000 to B

Step 2 – Exchange of Periodic Interest

A gives $20,000 to B and B gives €10,000 to B as interest

Step 3 – Re exchange of the Principal at the end of the Swap.

Now in this strategy, we can inculcate Equity swap Lets say if A is bearish on NASDAQ while B may think otherwise. A can pay return on NIFTY on a notional principal and B can pay interest rate on the same notional principal.

Therefore to hedge the swap, one needs to take a position and have an outlook about the future trend and decide accordingly.