Financial Risk Manager Part 1
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An investor wishes to purchase a 5-year BBB-rated bond issued by BAC Corporation but does not want to bear the out-of-pocket costs and the inconvenience associated with long-term financing arrangements, actually going long the bond, and taking delivery. Suppose also that a bank owns the same bond and would like to extend a loan to BAC Corporation but its loans to BAC and investments in BAC debt instruments have fully exhausted its capacity to lend to BAC. Which of the following instruments would best suit the two parties in these circumstances?
Other
Community
TTanishq
A
Credit spread swap option
B
Total return swap
C
Credit default swap
D
Collateralized loan obligation
Explanation:
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
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