TROR

[higaurav]

Hi David,

In TROR - TROR payer pays any asset appreciation and receiver pays any reduction in the value of the asset - is this correct ? As I can not figure out this concept from the study notes but came across in this question. Pls help.

Q Shell Oil has borrowed USD 100 million from BBVA at a fixed rate of 9%. To hedge its
exposure, BBVA enters into a Total Return Swap whereby it will pay the interest on the
loan in exchange for LIBOR plus 30 basis points. What is the net cash flow for BBVA if,
on the first settlement date, the market value of the loan has increased by 1% and the
LIBOR rate is 8.70%?
a. Net cash outflow of USD 1 million
b. Net cash inflow of USD 1 million
c. 0
d. USD 555,000
CORRECT: A
In a total return swap, BBVA must pay the interest on the loan in exchange for LIBOR
plus 30 bps. In addition, BBVA must pay the change in value of the asset if it goes up
(and would receive the change in value of the asset if it goes down).
In this scenario,
BBVA payments are: 9% + 1% = 10%
BBVA receives: 8.70% + 0.30% = 9%
So, the net flow to BBVA is an outflow of 1%, or USD 1 million.
Reference: Gunter Meissner, Credit Derivatives. Chapter 2.

 

[David Harper CFA FRM]

Hi OM,

This 4-min brief on TROR may help.
Here, BBVA is the TROR Payor: BBVA is transfering credit risk (and market risk). BBVA pays the total return on the bond: 9% coupon + 1% appreciation. As the credit risk has been transferred to the TROR receiver, BBVA is recieving LIBOR + spread.

David