Question

A fixed-income portfolio manager believes that within one year the credit spread of ABC firm will fall. Next week, ABC Corporation will be coming to market with a 15-year senior bond issue at par with a coupon rate of 8%, offering a spread of 400 basis points over the 15-year Treasury issue. Rather than purchase the bonds, the fixed income manager prefers to express her view on the company’s credit risk by entering into a total return swap that matures in one year with the reference obligation the bonds that will be issued by firm ABC. The total return swap calls for an exchange of payments semi-annually with the total return receiver paying the six-month Treasury rate plus 200 basis points annualized. The notional amount for the contract is $10 million. Suppose that over the one year, following occurs:

• the six-month Treasury rate is 4% initially

• the six-month Treasury rate for computing the second semi-annual payment is 5%

• at the end of one year the 14-year Treasury rates is 5%

• at the end of one year the credit spread for the reference obligation is 300 basis points

What is the net payment of this total return swap? Is the receiver making or losing money?

Answer 1

Considering the above scenario it can be said that ABC firm is likely to make 400 basis point.On the other hand, it has been seen that it is having obligation of 300 basis points. Along with that, payment will be initially 5%. Hence, it can be said that initially there will be money making stage after some year there will be case of losing. The reason behind this is that, total return swap will be 13 million that is, (10 million * (8% - 5%)).