Total Return Swap (Crouhy) - Figure 12-7 - mistake?

[emilioalzamora1]

Hi All,

in Crouhy's book it says the following about a Total Return Swap:

the purchaser of the TRS makes periodic floating payments, often tied to LIBOR. The party selling the risk makes periodic payments to the purchaser, and these are tied to the total return of some underlying asset.

In Crouhy the Bank obviously acts as the protection SELLER and the investor acts as the protection BUYER.

This cannot work in my opinion! Why should the bank act as protection seller?

In David's example (125.3) it is the opposite. David says

'where the protection seller pays LIBOR + spread'

However, according to Crouhy's figure 12-7 it should be: the bank acting as protection seller, receives LIBOR.

Can someone please clarify this?

Thank you!

 

[David Harper CFA FRM]

Hi @emilioalzamora1 I assume you refer to 12-5 (see below) rather than 12-7? Is so, yes this is a totally understandable confusion. Crouhy is semantically unusual here (maybe because this book attempts to simplify?). But please note Crouhy has the bank as a seller of credit risk, not a seller of credit protection. That is,

• Bank = selling credit risk = buying credit protection --> pays interest income and Δ value on the reference
  
• Buyer of credit risk = selling credit protection --> pays LIBOR + spread

I've been doing this for years and Crouhy's semantics are unusual. Almost everybody else (in the academic context) refers to "protection buyer" or "protection seller;" e.g., my question 125.3 is based on Culp. However, the TROR (aka, TRS) is an instrument that doesn't lend itself to buyer/seller (just like the interest rate swap). I think much better (more intuitive) is swap payer and swap receiver; e.g., see Janet Tavakoli who would know from experience http://www.tavakolistructuredfinance.com/trs/ Thank!

 

[seidu]

Thanks

 

[emilioalzamora1]

many thanks, David! Apologies,I was referring to Crouhy's first edition in my question (there it is Figure 12-7). Now it makes good sense.