Confused on when you factor in the movement in the underlying equity index and when you disregard that and treat it like it returning to its notional value upon each settlement. I feel like I missed something in that reading obviously?? Thanks in advance…
The payments for the equity leg are computed by using the return on the equity index:
(ending price / beginning price) – 1
This return is multiplied by the notional value to get the equity leg payment.
When you’re computing the value of an equity swap, you calculate the value of the fixed or floating leg as if it were a bond (just as in a plain vanilla interest rate swap) which includes the notional value. The value of the equity leg is the notional value increased by the equity index return since the last payment date.
In essence, on each payment date you increase the notional value by the return, but that return is paid to the counterparty, so the value returns to the notional to start the next payment period.