Equity Swaps As An Instrument To Diversify Risk Internationally

In this section we illustrate how an equity swap could enable a small country to diversify risk internationally without violating possible restrictions on investing capital abroad. If the small-country pension funds which already own the domestic equity were to enter into swaps with a global pension intermediary (GPI). In the swap, the total return per dollar on the small country’s stock market is exchanged annually for the total return per dollar on a market value weighted-average of the world stock markets. This exchange of returns could be in a common currency, dollars, as described or adjusted to different currencies along similar lines to currency swaps. Foreign investors can get a benefit from the swap by avoiding the costs of trading in individual securities in the local markets and by not having the problems of corporate control issues that arise when foreigners acquire large ownership positions in domestic companies. Unlike standard cash investments in debt or equities, the default or expropriation exposure of foreign investors is limited to the difference in returns instead of the total gross return plus principal. Default on the part of a counter-party in a swap contract results in the flow of payments being interrupted: the other party loses the diversification the swap provided, which can be rebooked with a different counter-party.  The potential exposure of foreign investors is probably less for the swap than for direct transactions in individual stocks. Not only because swaps only imply an exposure to flows of returns, rather than to the total value of the underlying asset.  Swaps are over-the counter (OTC) instruments, traded outside organized exchanges.  Trading swaps implies no capital requirements although mark-to-market collateralizing of swaps is wide-spread; there are no specific rules governing conduct, including risk management, imposing centralized trading, defining clearing and settlement rules, and\ loss sharing rules in case of defaults. OTC derivative markets lack a formal structure; have no physical central trading place, and no clearing or settlement system. There is also no central mechanism to limit individual or aggregate risk taking and risk management is completely decentralized.