Facing issue with understanding Total return swap

[BHeng9611]

Hi all,

I have a question to ask regarding Total return swap. On one of bionic turtle slides, it says buyer make regular payment of SOFR + bps x notional amount of loan to seller. However, on the next slides, it says seller make regular payment of SOFR + bps to buyer. I am confused. Is it the buyer who make regular payment of SOF x bps or the seller is the one who makes it? I am referring to FRM part 1 chapter 4 video.

Thank you in advance,
BX

 

[David Harper CFA FRM]

Hi @BHeng9611 We clearly could have done a better job in that transition (apologies) but it's a common problem with TRS. Here is why:

• Typically, the "buyer" of the TRS is buying the credit risk which is the same as selling credit protection: they are making the period fixed/floating payments indexed on SOFR (previously LIBOR + margin)
• The "seller" of the TRS is selling credit risk which is the same as buying credit protection: they are receiving the "safer" (SOFR + margin) and paying the coupon plus price appreciation.

See https://forum.bionicturtle.com/threads/total-return-swap-crouhy-figure-12-7-mistake.9923/post-45584
I think Hull's terms are just easier to follow, he uses "total return payer and receiver"; e.g., https://forum.bionicturtle.com/threads/total-return-swap-fall-in-asset-value.10107/post-50381

I hope that reconciles!

 

[BHeng9611]

okay, I understand already. I find it weird that for CDS, we define buyer to be the protection buyer (ie the bank) but for TRS, buyer refers to the buyer of credit risk, (ie the dealer), not protection buyer. Dont have consistency in defining the buyer for each credit derivative.

Thank you for your prompt reply.
BX

 

[yLam4028]

Hello if you are in doubt here are GARP's words. For my last FRM exam I would say it is a MUST to know the answer to the question ' if I want to hedge some credit risk I should long / short a TRS'

 

[gsarm1987]

Hello if you are in doubt here are GARP's words. For my last FRM exam I would say it is a MUST to know the answer to the question ' if I want to hedge some credit risk I should long / short a TRS'

View attachment 4117

Total return swap implies you swap the exposures 100%. thats a package including all the associated risks, be it market, credit, liquidity whichever is associated with the security. other hedging tools might mitigate market risk (futures) or just credit risk (CDS) but TRS is the total thing.

 

[capri]

Hi, I'm not quite clear on the structure of leveraged total return swap in P1. T1. Chapter 4, Figure 4.5, especially on the collateral portion of the total return receiver. Also, could you explain the 2 bullet points in the second snapshot attached please, I'm confused by the use of "buyer". Much appreciated.

 

[Clay Carter]

Hi, I'm not quite clear on the structure of leveraged total return swap in P1. T1. Chapter 4, Figure 4.5, especially on the collateral portion of the total return receiver. Also, could you explain the 2 bullet points in the second snapshot attached please, I'm confused by the use of "buyer". Much appreciated.

View attachment 4308

View attachment 4309

Hi @capri I will summarize the points as best as I can below:

A leveraged TRS involves two parties:

Total Return Receiver (TRR): This party seeks leveraged exposure to the underlying asset (bond, loan, etc.) without actually owning it.
Total Return Payer (TRP): This party agrees to pay the TRR the total return (interest payments + price appreciation) on the underlying asset in exchange for a fixed interest rate.

The TRR can achieve leverage by putting down a smaller initial investment compared to the notional amount of the swap. For example, the TRR might only need to put down 10% of the notional amount, effectively leveraging their exposure to the underlying asset by a factor of 10. However, the TRP will typically require collateral to mitigate credit risk.

To summarize the two questions at the bottom of your picture:

1. When an institution fully collateralizes the underlying instruments, it means they've set aside assets equal to the full value of the swap. This ensures that even if the bank were to default, there are sufficient assets to cover the obligations. However, there is still a cost to the firm for setting aside those assets that could be used for other projects which is why we equate that cost to the bank's funding costs.

2. The use of leverage includes greater risk and thus should result in a higher funding cost (thus the spread acts as a risk premium). Since the entire asset isn't backed by collateral, there's more risk for the seller.