Can someone please confirm whether my understanding of the swap is correct: The inv bank makes payments based on the total return of some portfolio of junk bonds In return the investor makes payments at a floating rate If the above is correct, how could an investor with junk bond exposure use the swap to hedge some of their market and credit risks?
swaps Hi Yes - your description of a total return swap sound fine. How would you use it? If I had a portfolio of junk bonds and was worried about the market and credit risk, I could enter into this swap, being the payer of the junk bond return and the receiver of the LIBOR. If credit quality becomes a worry in the markets, the junk bond portfolio would fall, and I would lose money (because I own a junk bond portfolio). But my payments under the swap would fall because I pay the return on a junk bond portfolio (which would be low or even negative). this acts as a hedge because the LIBOR payments would be unaffected (which I receive). Likewise If I was worried about the market risk caused by rising interest rates, I would do the same. If rates rise, my junk bond valuation sinks and I lose money, but the "return" that generates my payments under the total return swap would be low or negative again. the problems are all about the notional junk portfolio that drives the swap not being equal to the actual junk that you hold!
