Schweser 2009 Practice Exam Volume 1, Exam 2, Q 14.4 Is Total Return Swap a credit derivative ? It seems to me that Total Return Swap is not a credit derivative. Anyone can clarify ?
i think it should be one of those credit derivatives wherin you pay return on a reference asset (which can be subject to credit risk) and receive a floating payment in exchange. a more formal def avbl from net: A total return swap is a swap under which 2 partoies periodically pay each other total return on 1 or 2 reference assets that the dont necessarily hold. when atleast one of the assets is a credit-sensitive instrument, the swap is a credit derivative. payment betwen 2 parties are netted.
also to add: credit default swap: only transfers credit risk total return swap: transfers both credit risk and market risk of ref. asset
level3aspirant, TKVM !
If we are referring to counterparty credit risk then don’t most derivatives have the credit risk associated with them and therefore all of these would be considered credit derivatives? I was under the impression a TROR swap is one where two parties agree to transact based upon the performance of Asset A versus Asset B (eg. exchange return based upon performance of the S&P 500 versus the performance of the Nikkei).
BTON04, You mean all derivatives can be considered credit derivatives ?
I was not clear as to why TROR is considered a credit derivative therefore I stated my understanding of TROR is the second paragraph ( I was under the impression a TROR swap is one where two parties agree to transact based upon the performance of Asset A versus Asset B (eg. exchange return based upon performance of the S&P 500 versus the performance of the Nikkei). If the issue is about counterparty credit risk then all derivatives transacted between two parties has credit risk associated with it. But I did not comprehend the original intent of the question being so. So the question is 1) is my understanding of TROR incorrect, 2) or if we are referring to counterparty credit risk, then all OTC derivatives are considered to be credit derivatives (even though not explicit i.e Credit Default Swap etc).
BTON04, I think not all derivatives can be considered credit derivatives. But it seems that Total Return Swap is credit derivative.
The answer to the the question is, it depends on what the sides of the TRS are. If you are exchanging the return on a fixed rate loan for the total return on a broad stock market index than yes. If you are exchanging the return on a small cap index for the return on a broader market stock index than the answer is no. The question posed “Is Total Return Swap a credit derivative” is pretty much irrelevant. What we need to know for the exam in regards to total return swaps, is how they are used to diversify a portfolio or alter allocations between stocks and bonds (LOS 43 G). Answer to LOS: Definition: equity swaps obligate one party to make payments based on the total return of some equity index, with the other party paying a fixed rate, floating rate, or total return on another equity index. Diversification: if a portfolio is concentrated you can exchange returns on the asset for returns on a more diversified index (for a period). These swaps are also used to diversify internationally by swapping domestic returns for returns on an international index. Swaps also shift portfolio exposures for a period (Tactical Asset Allocation).
Can someone explain how does total return swap helps to transfer credit risk to the dealer please ? If the asset increases in value, dealer will gain and thus incur credit risk… but the asset holder has to get the gain in value from the asset and thus isn’t the asset holder still exposed to credit risk? Thank you.
I think you may be confusing the credit risks involved here and what is being transferred to the Total Return receiver. The credit risk being transferred is the credit risk on the underlying (let’s say its a corporate bond). The total return payer transfers the credit risk (and interest rate risk) of the underlying to the total return receiver, by paying its coupons and total return to the receiver (like the receiver actually owns the underlying). If there is a credit event, the underlying falls. If interest rates rise, the underlying falls. So the receiver (dealer lets say) is taking on both the credit and interest risk of the underlying, and is willing to pay a floating rate to the total return payer to do so. Obviously a total return receiver would only engage in this swap if they believed the underlying would offer a gain in value above the amount they have to pay that was agreed upon in the contract.
There is also credit risk between counterparties in the swap, which is what I think you’re referring to, but that’s not what is being transferred. That is inherent in the nature of a swap or other two-sided derivatives. If the underlying experiences a gain, the dealer also incurs the credit risk of the total return payer defaulting on the swap obligation.
I hope I got all that right and it made sense.
Level one candidate on a level 3 forum? Hmm
Thanks a lot! think i have mixed it up with the counterparties risk!