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April 2014 Q5(ii)

O

omurice

Active Member
Hi,

From the ASET, one of the disadvantages of swap-based strategy is that if it is 'cash settled', the counterparty may need to deal in physical markets to hedge risk.

Would like to seek for clarification on the above as I don't really understand the sentence.

Thank you.
 
A counterparty to a swap would usually want to cover their risks, which often means buying the physical asset that they have agreed to pay the total return on. If that asset is not very marketable (large quantity I-L bonds), the asset may have to be sold at the end of the TRS to pay the total return, and this could cause a problem. The counterparty may price this into the swap at the start making it quite expensive for the other party. The bit about cash settled is not so important - most swaps are cash settled. Some TRSs have the ability to physically transfer the asset at the end rather than pay the change in value. In those circumstances the marketability of the underlying asset is not so important.
 
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