Financial Risk Manager Part 1
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An investor approaches a swap dealer wishing to engage in a total return swap. The underlying asset is $10 million principal amount of a 9% BB-rated 5-year corporate bond that has semiannual interest payments. The swap dealer agrees to pay the total return on this bond for the coming 6 months in return for payments based on (1) an interest rate of 6-month LIBOR plus a spread of 30 basis points and (2) a notional principal amount equal to the face value of the underlying asset, $10 million. At the swap date, the bond is worth par, and the 6-month LIBOR is 6%. Suppose that at the termination date, the value of the bond has still not changed. Determine the net payment and the party that is owed. (Use discrete compounding.)
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TTanishq
A
Net payment = $315,000; owed party is the investor
B
Net payment = $450,000; owed party is the swap dealer
C
Net payment = $0; no owed party
D
Net payment = $135,000; owed party is the investor
Explanation:
Explanation
In a total return swap:
- Swap dealer pays the total return on the bond (coupon payments + capital gains/losses)
- Investor pays LIBOR + spread
Given:
- Notional principal =
$10,000,000 - Bond coupon rate = 9% (semiannual payments)
- LIBOR = 6%
- Spread = 30 bps (0.30%)
- Bond value unchanged (no capital gains/losses)
Calculations:
Swap dealer's payment to investor:
- Coupon payment =
$10,000,000 × 9% × 6/12 =$450,000 - Capital gain =
$0(bond value unchanged) - Total payment from dealer =
$450,000
Investor's payment to dealer:
- LIBOR + spread = 6% + 0.30% = 6.30%
- Payment =
$10,000,000 × 6.30% × 6/12 =$315,000
Net payment:
- Net =
$450,000 (dealer pays) -$315,000 (investor pays) =$135,000 - Since this is positive, the investor receives the net payment
Therefore, the net payment is $135,000 and the investor is the owed party.
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