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chapter 4. credit risk transfer mechanisms

wooju7533

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p.8
"In the case when the buyer collateralizes all the underlying instruments, then there is no risk of default. In this case, the bank's floating payment would equate to the bank's funding cost.
If the buyer uses leverage, then the floating payment is the funding cost and a spread. This compensates for the risk of not having the entire asset all collateralized."

what is "bank's floating payment" ? as far as i understand, in TRS, the bank only pays the dealer the amount of the coupon(from the underlying instrument)

please detail explain..
 

David Harper CFA FRM

David Harper CFA FRM
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#2
Hi @wooju7533 I think we can improve the terminology here but you are correct: the basic TRS (aka, TROR swap) is unfunded such that the protection seller (aka, buyer of credit risk) is paying interest--in the typical example LIBOR + spread (hence the reference to "floating payment")-- and the protection buyer (aka, seller of credit risk is paying coupon + price appreciation. This basic TRS is unfunded. Then the quoted portion, I believe, refers to the protection seller (aka, dealer/bank, buyer of credit risk) who chooses to collateralize the exposure. If this bank funds collateral, then the collateral will have a funding cost. If fully collateralized, then in theory, the bank has purchased collateral to cover the exposure and the "bank's floating payment would equate to the bank's funding cost." If the bank colateralizes less than full amoung, that is leverage ... increasing toward the basic unfunded case. The vanilla TRS is unfunded: the bank deserves a full premium for incurring the credit risk. If the bank wants to collateralize some/part/all of the credit exposure, that will incur a funding cost that "cuts into" the net yield; if the bank collateralizes the entire exposure and virtually eliminates credit risk, there should be no net premium earned on the credit risk. Thanks,
 
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