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P2.T6.209. Credit Derivatives (Total return swaps)

Suzanne Evans

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Questions:

209.1. Helman Bank made a $200 million loan with a fixed rate of 4.0% per annum payable semiannually. Helman hedges by entering into a total return swap (TRS) under which it will pay the interest on the loan plus the change in marked-to-mark value of the loan; in exchange, Helman will receive LIBOR + 100 basis points. The swap settles semiannually. What is the net cash flow received by Helman on the first settlement if the mark-to-market value of the loan increases by +5.0% and LIBOR is 2.0%?

a. -$11.0 million
b. -$3.5 million
c. Zero
d. +2.0 million

209.2. A total return swap payer (aka, protection buyer) is the counterparty who pays the coupon (interest) on the reference plus (+) any increase in market value of the reference. In exchange, the TRS payer receives a payment linked to a reference interest rate; e.g., LIBOR plus a spread. This TRS Payer position is economically most similar to which of the following:

a. Short a credit risk-free asset plus long an interest rate swap (IRS)
b. Long a credit risk-free asset plus short an interest rate swap (IRS)
c. Short a credit risk-free asset plus long a credit default swap (CDS)
d. Long a credit risk-free asset plus short a credit default swap (CDS)

209.3. Portfolio Manager Sylvia has a long position (has purchased) a risky corporate bond that pays her a fixed-rate coupon. She is considering hedging her exposure with three derivative instruments: asset swap, credit default swap (CDS) and total return swap (TRS). In comparing/contrasting these derivatives, each of the following is true EXCEPT for:

a. A similarity between an asset swap and a total return swap (TRS) is that both will hedge market risk by exchanging fixed coupons for floating coupons
b. A similarity between a total return swap (TRS payer) and a long position in a credit default swap (protection buyer) is that both will hedge the credit default risk of the underlying bond
c. A difference between an asset swap and a total return swap (TRS) is that the asset swap will not hedge credit risk (neither deterioration nor default) but the TRS will hedge credit default and deterioration risk
d. A difference between a total return swap (TRS payer) and a long credit default swap (CDS) is that the unfunded CDS has counterparty risk but the TRS avoids counterparty risk

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