Chartered Financial Analyst (CFA) Practice Exam Level 2

An equity swap involves which type of returns?

1. Paying a fixed return on a commodity inventory

2. Paying a floating return on a bond

3. Paying a fixed return on a bond and a floating return on an equity index

4. Paying a fixed return on equity and a floating return on bonds

The correct answer is: Paying a fixed return on a bond and a floating return on an equity index

An equity swap is a financial derivative contract where two parties agree to exchange future cash flows based on the performance of underlying assets. In this case, the correct answer indicates that one party pays a fixed return, often linked to a bond, while the other party pays a floating return based on the performance of an equity index. The fixed return refers to a set amount that is predetermined and does not change over time. This structure provides certainty for the party receiving this fixed return, making it appealing for those who want predictable cash flows. The floating return is tied to the performance of an equity index, meaning that this payment will fluctuate, depending on the market performance of the equity index involved in the swap. This allows the party taking the floating return to potentially benefit from equity market gains. This combination of fixed and floating return payments characterizes equity swaps, as they are often used by investors seeking to gain exposure to equity markets without directly holding the underlying equity securities, while also managing interest rate risks associated with fixed income investments.