Financial Risk Manager Part 1

Explanation

A total return swap is a financial derivative that transfers both the credit risk and market risk of an underlying asset. It involves two parties: the total return payer (or buyer) and the total return receiver (or seller). The total return payer receives the total return (including income and capital gains or losses) from a specified asset, and in return, pays the total return receiver a regular fixed or floating cash flow.

In this scenario:

• The investor can enter into a total return swap agreement with the bank as the total return payer, receiving the total economic return on the BAC Corporation bond without actually purchasing it
• This allows the investor to avoid the costs and inconvenience associated with long-term financing arrangements and taking delivery of the bond
• The bank, as the total return receiver, can reduce its risk exposure to BAC Corporation as if it had sold the bond, without actually doing so
• This arrangement allows the bank to extend a loan to BAC Corporation without exceeding its lending capacity

Why other options are incorrect:

• A. Credit spread swap option: This instrument allows swapping credit risk but doesn't address the investor's unwillingness to bear long-term financing arrangements and physical ownership
• C. Credit default swap: Provides protection against default risk but doesn't solve the issue of physical ownership and long-term financing arrangements
• D. Collateralized loan obligation: Involves pooling various types of debt into a single security sold to investors, which doesn't align with either party's needs in this scenario