Let’s illustrate the mechanics of a standard single-name credit default swap. Assume that the reference entity is the ABC Corporation and the reference obligation is the ABC Subordinated Debenture due 2110. The swap premium—the payment made by the protection buyer to the protection seller —is 550 basis points. If a credit event occurs, the protection seller pays the protection buyer the notional amount of the contract. In our illustration, we will assume that the notional amount is $10 million.
The notional amount is not the par value of the reference obligation. For example, suppose that a bond issue is trading at 73.53 (par value being 100). If a portfolio manager owns $13.6 million par value of the bond issue and wants to protect the current market value of $10 million (approximately equal to 73.53% of $13.6 million), then the portfolio manager will want a $10 million notional amount. If a credit event occurs, the portfolio manager will deliver the $13.6 million par value of the bond and receive a cash payment of $10 million. Read the rest of this entry »
By far, the most popular type of credit derivative is the credit default swap. It is categorized as one of two credit default products. Not only is this form of credit derivative the most commonly used stand-alone product, but it is also used extensively in structured credit products such as synthetic collateralized debt obligations, which will be discuss later. A credit default swap is probably the simplest form of credit risk transference among all credit derivatives. Because of the popularity of credit default swaps, the other type of credit default product —the credit default option—is rarely used. Hence, we will not discuss that product here.
Credit default swaps are used to shift credit exposure to a credit protection seller. Their primary purpose is to hedge the credit exposure to a particular asset or issuer. In this sense, credit default swaps operate much like a standby letter of credit or insurance policy. In contrast, a total return swap allows an investor to increase exposure to a reference obligation. Read the rest of this entry »
A total return swap in the fixed-income market is a swap in which one party makes periodic floating-rate payments to a counterparty in exchange for the total return realized on a reference obligation or a basket of reference obligations. A total return payment includes all cash flows that flow from the reference obligations as well as the capital appreciation or depreciation of those reference obligations. When the reference obligation is a bond market index, the swap is referred to as a total return index swap.
The party that agrees to make the floating payments and receive the total return is referred to as the total return receiver; the party that agrees to receive the floating payments and pay the total return is referred to as the total return payer.
Notice that in a total return swap, the total return receiver is exposed to both credit risk and interest-rate risk. For example, the credit risk spread can decline (resulting in a favorable price movement for the reference obligation), but this gain can be offset by a rise in the level of interest rates. Read the rest of this entry »
To give you a sense of how fund shareholders are serviced, let’s follow a typical series of transactions beginning immediately after a prospective customer decides to purchase fund shares. In the first step, the customer completes and returns an application for opening a new account to the transfer agent. The application may be returned in a number of ways, including by mail, at a branch office (if one exists locally) or through the Internet. Once the transfer agent receives the application, the transfer agent determines whether it is in good order. Although the definition of “in good order” can vary somewhat among fund complexes, many core elements are consistent. The transfer agent always makes certain to obtain a social security number or taxpayer identification number (in the case of corporate accounts) for tax reporting purposes. The transfer agent also ensures that the initial funding amount complies with any account minimums specified in the fund’s prospectus. If there is any issue with the application, the application is considered to be “not in good order.” In that event, the establishment of the account and the purchase of fund shares may be delayed until the issue can be resolved with the customer. Read the rest of this entry »
Buying and selling
Although some funds are exchange-traded, the shares or units of most mutual funds are bought and sold by making an application to the manager. This can be in writing, by telephone or via the Internet, directly by the investor or by the investor’s adviser or agent. Many managers have pre-printed application and redemption forms and their advertisements and other promotional mailing material often include an application form. Once accepted by the manager, applications constitute a binding contract, and the manager issues a contract note stating the details of the transaction.
For purchases, payment can be included with the application. Some managers may insist on this for the initial investment of a first-time investor. Alternatively, the contract note will specify when payment is required. For large investments, the manager may be required by law to obtain confirmation of the investor’s identification and of the source or destination of money involved in the transaction: if there is any suspicion that the money is being laundered, or used to support terrorist activity, the suspicion must be reported to the authorities. Read the rest of this entry »
