Pricing Total Return Swaps

Various credit derivatives may be priced using this model for example, credit default swaps, total return swaps, and credit spread options. The pricing of these products requires the generation of the appropriate credit dependent cash flows at each node on a lattice of possible outcomes. The fair value may be determined by discounting the probability-weighted cash flows. The probability of the outcomes would be determined by reference to the risk neutral transition matrix. 

The reduced form models described earlier models are a new generation of credit derivative pricing models, which are now increasingly being used to price total return swaps. 

Exhibit 21.4 illustrates a generic TR swap. The protection buyer has contracted to pay the total return on a specified reference asset, while simultaneously receiving a LIBOR-based return from the protection seller. The reference or underlying asset can be a bank loan such as a corporate loan or a sovereign or corporate bond. The total return payments include the interest payments on the underlying loan as well as any appreciation in the market value of the asset. The protection seller will pay the LIBOR-based return it will also pay any difference if there is a depreciation in the price of the asset. The economic effect is as if this entity owned the underlying asset, as such TR swaps are synthetic loans or securities. 

Alternatively, the traders can enter into a TR swap in which they pay the total return on the bond and receive LIBOR plus a spread. If the bond yield exceeds the LIBOR payment, the funding will be negative, but the trade will still gain if the bond falls in price by a sufficient amount. The traders will choose this alternative if the swaps break-even point— the price to which the bond must decline for a gain from the short sale to offset the trade s funding cost—is higher than in the repo approach. This is more likely if the bond is special. 

The swap is diagrammed in FIGURE 10.6. The arbitrt eur receives the total return on the bank loan and pays the counterparty bank the bond return plus an additional 30 basis points, the price of the swap. These rates are applied to notional amounts of the loan and bond set at a ratio of 2 to 1, since the bond s price is more sensitive to changes in credit status than that of the loan. 

---