Suppose that I enter an Equity Swap, such that I pay a floating rate and I receive the equity return. The payment is every one year for both the rate and the return, and the swap expires in one year. I have been told that shorting the stock should fully hedge the swap. However, I worked out the cash flows as follows:
Time | 0 | 1 | 2 | Pay rate | 0 | -S_0 * r_0 | -S_1 * r_1 | Receive Equity | 0 | S_1 - S_0 | S_2 - S_1 | Short Stock | S_0 | 0 | -S_2 | Reinvest | -S_0 | 0 | S_0*(1+r_f)^2 | Total | 0 | not zero | not zero |
r_f is the annual risk free rate, r_0 and r_1 are the annual floating rates.
Am I missing something here? Is shorting one stock enough or do we have to short another stock at time 1? How should the cash flows be?