Explanation:
In a total return swap, one party, the payer, is able to confidently remove all the economic exposure of the asset without having to sell it. The receiver of a total return swap, on the other hand, is able to access the economic exposure of the asset without having to buy it.
The party that agrees to make the floating payments and receive the total return is the total return receiver, while the party that agrees to receive the floating payments and pay the total return is the total return payer. The total return receiver is exposed not only to credit risk but also to interest-rate risk. If the credit risk spread declines, for example, there would be favorable price movement (price increase) for the reference obligation, but any gain made on that front can be offset by a rise in the level of interest rates.
Expecting the credit risk spread to decline (in line with the report) and not expecting interest rates to decline, Ms. Zane would enter the total return swap as the total return receiver. Based on the report, she has reasons to believe that the fortunes of Fortune Corporation will improve over the next year, triggering a decline in the firm’s credit spread relative to U.S. Treasury securities, which will, in turn, result in a favorable price movement. As the total return receiver, Ms. Zane would profit from the decrease in spread.
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Q.35 Hannah Zane is a fixed-income portfolio manager at Smart Capital. She comes across a research report issued by a major brokerage firm on Fortunes Corporation in which the research analyst argues that within one year, the Fortune’s credit fundamentals will strengthen. The report goes further to assert following the narrowing spread, the market will respond by demanding a lower credit spread. After reading the report, Ms. Zane decides that she wants to take a credit view on Fortunes Corporation. Next week, Fortunes Corporation has declared its intention to bring to the market a 10-year senior bond issue at par with a coupon rate of 12%, offering a spread of 800 basis points over the corresponding 10-year Treasury issue. Ms. Zane is not keen to purchase the bond outright because she does not want to bear the out-of-pocket costs, the inconvenience of arranging the financing, actually going long the bond and taking delivery. Instead, she would like to express her view on Fortune Corporation’s credit risk by entering into a total return swap that matures in one year with the senior bonds that are about to be issued as the reference obligation. Under the terms of the contract, payments will be exchanged semiannually, where the total return receiver will pay the six-month Treasury rate plus 350 basis points. Which of the following is most likely correct?
A
Ms. Zane’s counterparty will enter the total return swap as the total return receiver.
B
Ms. Zane will enter the total return swap as the total return receiver.
C
The total return receiver will be exposed to credit risk but not interest rate risk.
D
The party that agrees to receive the floating payments and pay the total return is the total return receiver.