Total Return Swap

[srinu2singaraju]

Hi David,

Please clarify the following question:


Shell oil has borrowed USD 100 million from BP at a fixed rate of 9%. To hedge its exposure, BP enters into a Total Return Swap where by it will pay the interest on the loan in exchange for LIBOR plus 30 basis points. What is the net cash flow for BP, if on the first settlement date, the market value of the loan has increased by 1% and the LIBOR rate is 8.70%
Choose one answer.

a. Net cash inflow of USD 1 million

b. Net cash outflow of USD 1 million

c. USD 555,000

d. 0

The answer is B.(Why?)

My understanding is, in a Total Return Swap (TRS), the buyer of TRS will have to pass on all the gains/losses on the loan to the TRS seller (other than interest exchange). In the above question the market value of the loan has increased by 1%. So the net cash flow for BP should be inflow of USD 1 million from Shell. but the it is not the answer given.

Please clarify.

Srinivas

 

[archlight]

i suppose BP enters total return swap with a bank

 

[[email protected]]

BP has gone into a TRS agreement as the TR payer with a separate counterparty to hedge its exposure to SHELL.

BP will pay increases in market value and loan interest to the TRS counterparty in exchange for LIBOR plus 30bps.

On the first settlement date,

BP pays TRS seller 9% (loan interest) plus 1% (increase in market value) - total $10m i.e. 1% of 100m + 9% of 100m

BP receives LIBOR (8.7%) plus 30bps i.e. 9% from TRS seller - total $9m

Hence, BP has a net cash outflow of $1m to the TRS seller.

I think this is the logic to the answer

 

[waqas.munir]

Answer by gokonkwo makes sense. Just to add, incase the value of the instrument had declined, TR payer would have compensated BP for this . So BP makes MtM payments only in the case of an increase in the underlying asset.

 

[RomanS]

Hi,
does everyone agree with waqas.munir's answer? Actually I don't. Here is why:

(1) BP is the TR payer: BP pays the TR of the loan which is 9% + value increases or - value decreases.
(2) BP will always make payments as long as the loan has not decreased in value by 9% or more.

Just to examplify we can change the question and assume the loans lost 1% in value.

BP would receive 9% from Shell, i.e. +$9mn
BP would pay 8% (9%-1%) to the counterparty, i.e. -$8mn
BP's net cash flow would +$1mn

Do you agree?

 

[David Harper CFA FRM]

Hi RomanS,

I agree with waqas.munir. I think the question implies to query the net cash flows with respect to the swap only (and not the underlying loan to BP; IMO the question could be more precise by stating it refers to swap cash flows only).

But, in your example of a loss of 1% in MV of the loan:
* In regard to underlying: BP receives 9% coupon interest from Shell (regardless, as long as no default)
* In regard to swap: BP pays 9% interest and receives 10% (ie, LIBOR + spread + portfolio depreciation of 1%) = NET receive 1% on swap

And it confirms the hedge works in the depreciation scenario:
the +1$ mm gained on the swap is offset by the -$1MM loss in MV on the underlying loan.

David

 

[RomanS]

Hi David,
thanks for the reply and the correction. Your are of course right and so is waqas.munir.

Just one minor thing in the reply from waqas.munir:

It is the protection seller who would have compensated BP and not the "TR payer would have compensated BP". BP is the TR payer or alternatively the protection buyer.

Best Roman

 

[Jiew Kwang]

I was looking TRS on youtube and found a video by david and i think it helps to draw a picture out.

I think the confusing part at first was that BP is lending shell 100m @ 9%.

However the TRS reverses this process and i cannot understand from the question what is the logic of lending someone money and buying protection from the same person that is issuing debt from you..

So shell is borrowing 9% from BP
Shell ---9%-->BP

In the TRS,
Shell is paying LIBOR 8.7% + 0.3% to BP and receiving 9% which is the original loan interest + 1% change in value from BP. Therefore BP incurs an outflow of net 1% of 100m = 1m.

Anyway, i print screened the BT videocast and edited it to reflect my reasoning. (not very sure of this question though-i think its not worded well?)