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 »
A collateralized debt obligation (CDO) is backed by a diversified pool of one or more types of debt obligations (e.g., U.S. domestic investment-grade corporate bonds, high-yield corporate bonds, emerging market bonds, bank loans, asset-backed securities, and residential and commercial mortgage-backed securities). The funds to purchase the collateral assets are obtained from the issuance of bonds. There is a collateral manager responsible for managing the collateral of assets.
A CDO is classified as a cash CDO or a synthetic CDO. The adjective “cash” means that the collateral manager purchases cash market instruments. A synthetic CDO is so named because the collateral manager does not actually own the pool of assets on which it has the credit risk exposure. Stated differently, a synthetic CDO absorbs the credit risk, but not the legal ownership, of the reference obligations. A credit default swap allows institutions to transfer the credit risk, but not the legal ownership, of the reference obligations it may own. 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 »
