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Credit default swap is the most commonly known derivative which is based on swaps. However, it is not the only one. There are many types of swaps that are used for managing credit risk. In this article, we will have a look at the total returns swap which is commonly used in credit risk management.
Let’s assume that investor A purchases a bond from a company B. Company B has promised to pay A in the form of coupon payments as well as principal payments. Also, there is a change in the market price of the bond from time to time. If A does not want to hold the bond to maturity, they can sell it at the prevailing price. The combination of the three types of returns i.e. principal, interests as well as delta change in market rate is collectively known as total returns.
It is important to note that all three types of returns are impacted by credit risk. There is always a chance that the company may go bankrupt and may not be able to pay the principal or the interest. Also, the market rate may be affected even if the company does not default on this bond but defaults on some other bond.
In order to secure themselves against this credit risk, investor A can opt to purchase a total returns swap. As the name suggests, the swap will be a contractual obligation whereby investor A will give all the cash flow related to the reference asset to a third party C. In return, C agrees to provide a benchmark fixed or floating interest rate. In most cases, the agreed rate is based on LIBOR.
Investor A i.e. the party who agrees to give up the total return in exchange for a fixed fee is called the total return payer. The other party in the contract receives the total return and hence is called the total return receiver.
A total returns swap exists only because of the difference of opinion between two parties. The total return payer believes that the discounted value of the fixed or floating rate cash flow is more than the discounted value of the total returns. On the other hand, the total return receiver believes the opposite i.e. the discounted value of total returns is more valuable. However, since this is a derivative contract it is a zero-sum game. This means that the amount of money lost by one party will be exactly equal to the amount of money gained by the counterparty. Therefore, in the end, only one of the investors turns out to be right.
There are several advantages of total returns swap which make it very popular amongst the investing community. Some of them have been written below:
There are many variations of the total returns swap out there. One of them is called the total rate swaption. The word swaption is derived from the word “swap” as well as “option”. This means that technically there is no swap that starts taking place immediately. This means that for the time being, both investors A and C will hold on to their respective cash flows.
However, A will pay a premium up front in order to purchase an option. This option would give A the right but not the obligation to swap the cash flows at a later date.
So, A has to pay an amount upfront and would gain only if the value of the total return falls down in comparison to the benchmark rate. On the other hand, if the benchmark rate remains higher, then the cash flows are never exchanged and investor C can just pocket the premium which they charged for writing the option.
Total returns swap has a fairly large and liquid market worldwide. They are sold in large quantities over the counter. At the moment, these contracts are not traded over the exchange. However, it is fairly easy to get one in almost any part of the world.
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