Credit derivatives are financial instruments whose value is derived from an underlying credit asset like a bond or loan. The two main types are credit default swaps and total return swaps. Credit default swaps allow one party to transfer the credit risk of a bond or loan to another party. Total return swaps transfer both the credit risk and interest rate risk of the underlying asset. These instruments allow investors to take on or reduce exposure to specific credit risks.

1. Credit Derivatives – core
concepts
Credit derivatives are instruments whose value is derived from that of an underlying bond, loan or
other credit agreement. They are used to assume or lay off credit risk in isolation from other types
of risk. The two main instruments are credit default swaps and total return swaps and they:
1. enable holders of credit risk, such as banks, to lay off the credit risk in their loan, bond and
derivatives portfolios without having to sell the underlying credits upon which their
relationships may be based. This makes true credit portfolio management possible.
2. are an alternative to asset swaps for institutions unable to buy high-quality assets for funding
cost reasons, or unable to access the loan markets directly, to gain their desired credit exposure
on an unfunded basis (or, if embedded in credit-linked notes, on a funded basis.)
3. provide a mechanism for BIS capital management as they allow banks to remove assets from
their balance sheets particularly at key time regulatory capital requirements for banks are often
calculated on peak credit exposure at the end of reporting periods and can attract lower
regulatory capital than the cash equivalent.
4. allow synthetic assets to be created that do not exist in the markets.
5. allow hedging of contingent credit risks embedded in assets hedged with currency swaps.
6. allow corporates to hedge the credit exposures they have to other corporates via trade
receivables and long-term purchase contracts and to their banks via long term trade financings,
loan facilities such as revolving credits and swap and option portfolios.
7. allow corporates and banks to hedge against emerging market risk where guarantees are not
available or export agency cover is expensive.
8. create a link between the bank and insurance markets vastly increasing the capacity of both to
absorb credit risk. In sectors where corporate demand for insurance is so great that there is no
more reinsurance capacity, insurance and reinsurance companies can use a default swap to go
short the default risk of a basket of credits issued by entities in that sector so freeing up their
lines in that sector. See chapter 16 for: credit-linked notes credit-spread linked notes, first to
default bonds, repackaged notes, sovereign default notes

2. Definitions
Asset swap
A transaction which transforms the cash flows of a security through the application of one
or more swaps. For example, bond coupons can be swapped from fixed to floating rate or
vice versa; interest and principal can be swapped into a different currency; the yield from
a security can be swapped for a cash flow based on an index in another asset class. An asset
swap transaction involves three distinct steps: an asset is purchased for cash; the cash flows
are swapped into the desired form; the package consisting of the asset and the swap(s) is
held by the investor these are on-balance sheet items.
The most common type of asset swap is the par asset swap. Here the notional amount of
the swap is equal to the face amount of the underlying asset. The asset is purchased for par
and the investor receives par at maturity. The other vanilla asset swap is the market value
asset swap. Here the notional amount of the swap is equal to the market value of the
underlying asset at the time the trade is executed. See repackaged securities for an
explanation of the link between vanilla asset swaps and true credit derivatives.
A number of important variations allow for more tailored transactions. Callable asset swaps
and step-up callable asset swaps are used where the underlying asset is either callable or
step-up callable. The swap matches the coupon and callable features of the underlying.
They are also used in convertible asset swaps (also known as stripped
convertibles/converts).
Here the underlying asset is a convertible bond. Typically a bank purchases a convertible
and sells it to an investor for its fixed-income value. The investor then enters into a swap
the asset swap with the bank exchanging the fixed-rate coupon payments on the convert
for a floating rate. The swap agreement also contains an option giving the bank the right to
call the bonds back at any time and so terminate the agreement (hence the asset swap is
callable). The investor effectively holds a callable floating-rate note backed by the credit
of the convertible issuer. He has given up the equity option embedded in the convertible
the option has been ‘stripped’ from the convert in return for a higher spread on the swap.
The bank now owns the equity component of the convertible as it can call the bonds to
extract any appreciation in the value of the equity option.
Callable and puttable asset swaps are also used to take views on changes in credit spreads
they are sometimes viewed as the first credit derivatives and in this context are often
referred to as credit spread options (see below). Other structures include cross-currency
asset swaps in which the coupon of the asset is swapped into a different currency; forward-
[starting] asset swaps which can be used by investors wishing to take advantage of a steep
credit curve for a specific issuer. These are also known as knock-out asset swaps as if the
underlying asset defaults before the start date of the swap, the forward swap is cancelled;
maturity-shortened asset swaps where the maturity of the swap is less than that of the
underlying asset; and asset swaps can be combined with other options, such as caps, floors

3. and collars, to give more tailored payoff profiles. See also switch asset swap .
Contingent credit risk
Indirect credit risk such as that embedded in assets hedged with currency swaps.
Example
The arrangers of bond repackaging face contingent credit risks. Suppose a bank can buy
Brazilian Brady bonds cheaply in the US market but cannot sell them into Europe because
of their unusual floating coupon and amortization schedules. It places them into a special
purpose vehicle (SPV) and swaps them into fixed-rate Deutschmark bullet bonds. The
underlying bonds are placed in a trust and swapped using a cross-currency swap. Most SPV
structures have triggers that force early redemption of the new bonds and the unwind of
the SPV in the event that collateral levels fall below predetermined thresholds. So, if credit
spreads rise, or in the extreme the bonds default, the swap has to be unwound as the
structure is dismantled. If the dollar strengthens against the Deutschmark the bank will lose
money on the swap unwind. In an extreme case, the residual value of the bonds may not be
enough to cover the shortfall, so there is a credit-related contingent foreign exchange risk.
To cover this risk, the arranger could take out default protection on the underlying
securities.
Similarly, banks run a quanto credit risk when cross currencies in an asset swap. For
example: a bank takes a dollar-denominated asset and swaps it into yen using a cross-
currency swap. If the underlying asset defaults and the swap is unwound there will be a
windfall gain or loss on the swap. Bankers recall deals when USD/JPY traded at 250 that,
if they defaulted at today’s exchange rate, would incur windfall losses as large as the
bond principal. One way to hedge is to take credit exposure in dollars and buy credit
protection in yen. But the size of this hedge must be managed dynamically in the same
way as the risks embedded in quanto instruments.
[Credit] default swap

4. A swap agreement in which one counterparty (the protection buyer, risk seller, hedger)
pays a fixed periodic fee, usually expressed in basis points per annum on the notional
amount, in return for a payment by the other counterparty (the protection seller, risk
buyer, investor) contingent upon a specified default event relating to an underlying
reference asset (a loan, bond, stream of trade receivables or derivative contract cash
flows). While there is no default event, the protection buyer pays the swap counterparty
the periodic coupon. If the specified credit event occurs there is an exchange of cash
flows and/or securities designed so that the net payment to the protection buyer mirror the
loss incurred by creditors of the reference credit in the event of its default. This exchange
of cash flows usually follows one of three patterns depending on the liquidity and
availability of the reference securities:
1. Physical delivery: the protection seller pays full notional amount in exchange for
defaulted reference securities
2. Cash-settled recovery value-linked payment: the protection seller pays the
counterparty an amount calculated as the fall in the price of a reference security
below par after default as established by polling reference dealers. So a typical cash
settlement formula would be [(par – recovery value) x notional principal of swap].
The price of the reference asset can be determined either as an average determined
over a three-month period or via a single poll.
3. Cash-settled binary payment: the protection seller pays the counterparty a
predetermined fixed amount or pre-determined percentage of notional is payable.
This structure is sometimes known as a digital credit swap. Because they are
difficult to price and hedge digital credit swaps command a premium most hedgers
consider too expensive. The economic effect of the transaction is to allow the holder
of an exposure to a particular counterparty to transfer the risk of that counterparty’s
default to a third party without transferring the underlying asset itself. The third
party the protection seller assumes the credit risk of the exposure in exchange for
the return from it and so generates investment income with no funding costs. Credit
default swaps with the same maturity as the underlying asset are equivalent to the
underlying asset but with the interest rate risk immunized. That in turn means that
they are the same as total return swaps (see below) with the interest rate risk
immunized. Hence the pricing is directly comparable to asset swaps.
The periodic coupon is generally derived from the Libor spread received by an
investor in the underlying obligation in the cash or asset swap market. The asset
swap market spread is the benchmark because the default swap is an unfunded
transaction. To replicate it in the cash market would require an investor to borrow
the underlying bond through the repo markets. On average, repo financing for high-
grade corporate assets is available at Libor flat, so the investor’s spread on the trade
is a spread to Libor. This arbitrage, where it is available, constrains the pricing of
default swaps.

5. However, hedgers generally have to pay a premium to this Libor spread depending
on the tenor of the swap and the liquidity of the underlying bond. The swap is
generally less liquid than the underlying, which means investors demand more for
taking the swap than they would the bond. On the other hand, as the transaction is
unfunded, it gives institutions with high funding costs access to assets they would
not normally be able to purchase without incurring negative carry. Default swaps
are also often structured with maturities different to that of the underlying exposure.
This creates synthetic investments that are not available in the cash markets. Both
these factors can make the swap more desirable than a cash investment and drive
the price down. In addition, in a credit default swap the protection buyer has a credit
exposure to the protection seller contingent on the performance of the reference
credit. If the seller defaults, the buyer must find alternative protection and will be
exposed to changes in credit spreads since the inception of the original swap. So
protection bought from higher-rated counterparties should command a higher price.
Also, the protection buyer must also take into account the correlation between the
risk of default of the seller and the hedged exposure. If there is a positive
correlation, then default by the underlying borrower may imply that the swap
counterparty’s ability to deliver the notional value of the reference security is
impaired. At worst this might means that the reference credit and protection seller
default simultaneously in which case the buyer is unlikely to recover the full default
payment due.
Credit default swap maturities usually run from three months to 10 years and
transaction sizes range from USD5 million to USD300 million. Bid/offer spreads
range from 50bp to 150bp. The main participants in the market are banks. Also
known as a credit swap, and also, particularly if instead of paying a periodic fee the
protection buyer pays a one-off upfront payment, as a [credit] default option.
Strictly speaking though, since the swap contains no optionality, it is not a true
option.
Credit default exchange swap

6. A type of default swap in which investors swap the default risk of one asset or basket of
assets for that of another. Each party serves simultaneously as a protection buyer and a
protection seller. These swaps are used mainly by commercial banks who want to hedge
concentration risk in their loan portfolios in a single unfunded transaction without buying
and selling packages of commercial loans.
Example
An investor seeks exposure to a loan yielding libor + 350 basis points that a double-A rated
bank has made to a Turkish corporation. The investor enters into a total return swap with
the bank – the total return payer under the terms of which it pays three-month Libor +100
basis points and receives Libor + 350 basis points plus or minus any change in the market
price of the loan. If the loan’s market value remains unchanged over the life of the contract,
then the investor earns 250 bp on the transaction. However the investor bears both the price
risk and any early repayment risk on the loan over the life of the agreement.
Credit spread
The yield of a security or loan less the yield of a corresponding risk free security. Plotting
credit spreads the premium over the benchmark against bond maturity produces the credit
curve for a borrower. In theory this margin compensates investors for the risk of default.
In practice it is also affected by liquidity considerations and and number of other market
factors. Credit spreads can be traded with credit spread forwards and options. The key
variables in trading are the term structure and volatility of credit spreads. The forward
credit spread is calculated as follows: the forward prices of the security and the risk free
benchmark are calculated and converted to the corresponding forward yield. The forward
credit spread is the forward security yield less the forward risk free rate.
In theory the credit spread should increase in line with increasing default risk and maturity.
In practice, forward credit spreads increase in the case of a positively sloped yield curve
but do not seem to reflect investor expectations. Forward credit spreads appear to be a poor
indicator of future spot spreads and seem relatively more volatile than the underlying
securities. This higher spread volatility reflects the absolute lower level of spread and the

7. imperfect correlation between the yield on the security and the risk free rate.
Credit spread forward
Equivalent to a forward asset swap these are forward-starting transactions which enable
credit spread trading/hedging at a future date. Credit spread forwards allow counterparties
to express views on future credit spreads and benefit from a narrowing or widening of the
credit spread between debt instruments. One application is therefore for borrowers wishing
to lock in future borrowing costs without inflating their balance sheet today. In the case of
a borrower hedging issuing costs the reference credit would also be the protection buyer
which significantly increases the counterparty risk to the protection seller. Collateralization
is being used to mitigate this risk.
Example
An investor wants to take advantage of steep forward credit curve by locking in wider
spreads in the future than are available today. He identifies an eight-year emerging
market bond that currently trades at Libor+70bp. Three-year bonds from the same issuer
trade at 30bp over. At current market prices, by agreeing to buy the eight-year asset in
three years’ time an investor will lock in Libor plus 95bp for the remaining five years of
its maturity 25bp more than eight-year assets today. The risk for the investor is that the
issuer’s credit fundamentals deteriorate over the the next three years and spreads widen
by more than 25bp. However, the downside is limited by the fact that if the issuer
defaults in the next three years then the investor does not have to buy the asset.
Credit spread option
Credit spread options are calls (puts) on a credit-sensitive asset with at a pre-determined
strike price expressed as a spread to an index typically Libor or to government securities.
They allow buyers to buy or sell the underlying asset at a pre-determined price for a pre-
determined period of time. The buyer of a credit spread call profits if spreads tighten. The
buyer of a put profits if spreads widen. The options are priced off the credit curve, expected
credit spread volatility and expected recovery rates.
The reference asset is usually either a floating rate asset or a fixed-rate asset swapped into
floating rate through an asset swap. Floating-rate reference assets are favored because the
floating coupon immunizes interest rate risk any change in the principal value of a floating-
rate asset is largely due to changes in credit perception. This means that, in general, credit
spread derivatives such as forwards and options are equivalent to forwards and options on
an asset swap.
So, for example, a put seller would be put into an asset swap paying par for the asset. The
seller would then pay the coupons on the asset and in return receive the pre-determined
spread over the Libor (the strike spread). Because of this, credit spread options are
equivalent to callable or puttable asset swaps and are sometimes known as asset swaptions.

8. Asset swap buyers can use these options to enhance yield by, for example, selling calls.
This exchanges upfront premium income against the loss of upside if spreads tighten.
Investors can also use combinations of calls and puts to lock in a current spread and
transactions can be structured that allow investors to go long or short the spread between
two different assets say two countries’ sovereign debt or benchmark corporate bonds of
different ratings or sectors. Institutional investors are now using credit spread options to
slice up a credit into different tenors. A sophisticated credit risk player might buy a five-
year bond and sell the first two years as a way of rolling down the credit curve.
Basket/portfolio spread options are also available in which the option is written on a basket
of reference credits rather than just one. For example, in a basket credit spread put trade an
investor increases its premium income by selling a number of puts, each linked to a
particular security at a particular strike spread. The buyer has the right to exercise the seller
into any one of the reference assets at its strike spread, in the full notional amount.
Example
Improvements in economic fundamentals in Hungary have created new credit lines. In the
Asian credit crisis five-year paper went from 35bp over to as wide as 100bp. Spreads are
now back at Libor + 40bp but some expect a retreat in the short run. An investor with a
price target of Libor + 50bp can utilize its new credit line while waiting for prices to move
to its entry level by writing one-year put options struck at the target spread. Typical terms
would be that the investor receives 25bp running yield for giving the option counterparty
the right to sell it bonds at the target spread. The income requires no balance sheet and no
funding requirements. If the spread remains below Libor + 50 bp the investor has earned a
premium of 25 bp multiplied by the notional principal of the contract which it can use to
buy the bond at a price below market (if it wants). If the spread has risen above the target
level then the option seller exercise their option to sell the bond at the strike spread and the
investor buys the bonds at its strike spread plus the premium which is the originally targeted
level. Alternatively the investor can settle the trade by paying the option seller the notional
principal of the contract multiplied by the difference in basis points between the final
spread and the strike spread. The higher the strike spread is above the current spread of the
reference asset, the more the credit spread put resembles a credit default swap in which the
investor pays a small periodic fee to buy protection against a large downward move in the
price of the reference asset.

9. credit spread exchange swap
A swap in which counterparties swap the credit spreads of two reference securities. This
allows them to take views on the relative spread between two comparable credit-sensitive
securities.
Example
An investor wants to monetize the expectation that the credit spreads of Brazilian Brady
bonds will narrow relative to those of Argentine Brady bonds. The investor chooses a
spread exchange swap structure that produces a pay-off tied to the difference in the spreads
of two Brady bonds. The trade uses the exchange of two absolute spreads pegged to a US
Treasury to to capture the relative spread of two reference securities. the investor pays the
dealer the notional amount multiplied by the credit spread between the Brazilian Brady
bond and the US Treasury. In exchange, the dealer pays the investor the same notional
amount multiplied by the credit spread between the Argentine Brady and the US Treasury.
If the credit spread of the Brazilian bonds falls relative to that of the Argentine bonds , then
the investor receives a payment from the dealer and vice versa. This kind of trade is
normally structured so that no payment is made unless a change in the relative spread
occurs.
First to default/basket default swap
A default swap in which there is not one but a basket of reference assets. The protection
buyer pays a fixed periodic payment, usually expressed in basis points per annum on a
predetermined notional principal.
The protection seller makes no payments unless some specified credit event relating to any
one of the reference securities in the agreed portfolio occurs in which case the protection
seller is obligated to make a payment based solely upon the defaulted security. In other
words, the swap only pays out on the first default which occurs in the basket. Other defaults
are not hedged. The investor receives a return approximately equal to the spread of the
worst names in the basket plus an additional correlation dependent spread for each of the
other names in the basket. The additional spread is based on the commitment fees on

10. unfunded loans for those names.
These transactions started off with six or so reference assets and banks are now executing
$1 billion-plus default swaps on a basket of between 30 and 50 credits. These larger deals
are essentially the same as a privately placed unfunded collateralized loan obligation. This
type of synthetic securitization has two key benefits over standard CLOs or credit-linked
notes. First, it is cheap: because it is unfunded it allows a strong bank to maintain its sub-
Libor funding spread. Second it is extremely flexible: as the assets remain on the banks
balance sheet rather than being having to be transferred from different branches or legal
entities into a special purpose vehicle which can cause internal, regulatory, legal and tax
problems.
First to default swaps generate much higher returns than through a single investment in any
of the other names. As long as the basket is diversified, the hedging institution lays off
exposure more cheaply than hedging the names individually. Also known as
basket/portfolio (credit) default swaps.
Market contingent credit derivative
Credit derivatives whose payout depends on the mark-to-market value of an underlying
credit exposure and is contingent upon that value being negative. A hedger would
determine its maximum expected exposure on a credit or group of credits (these could be
securities or derivatives positions) if those credits were to default. It would then enter into
a market contingent credit derivative with a notional amount equal to this exposure. The
hedger pays a commitment fee say 15bp on the notional amount of the agreement unless
the mark-to-market exposure on the interest rate or currency position becomes negative. In
that case the institution pays the full hedging cost of the reference party but just on this
negative amount. In the case of default, the buyer of the hedge would have protection equal
to the unwind value of the underlying position. This is much cheaper than using a standard
credit derivative because the hedger only pays for credit protection when it is needed when
the mark-to-market value falls below zero. If the mark-to-market value remains positive,
then the commitment fee paid will typically be around half the cost of fully hedging the
underlying credit risk. See swap guarantee.

11. Mark-to-market cap
An interest rate hedge structure that puts an upper limit on the mark-to-market loss of a
swap or a swap portfolio. The portfolio version gives the client to enter into a portfolio of
offsetting swaps at any reset period over a chosen period, at strikes that ensure that the
mark-to-market loss will not exceed a predetermined amount. The premium depends on
the underlying parameters of the swap portfolio: tenors, notional amounts, strikes,
correlations and embedded option features. Protection on a portfolio basis is cheaper than
buying caps on the individual swaps.
Example
A corporate treasurer may have a series of interest rate swaps on his books, hedging a
variety of underlying debt obligations. This treasurer was previously not required to mark
his swaps to market, but recent accounting changes force him to. In this case, he wants to
limit any adverse bottom line effects. Suppose he has a portfolio of five receive-fixed swaps
maturing at different dates between October 1996 and October 1998 which currently show
a mark-to-market loss of $4 million. A mark-to-market cap would provide the company
with an option to enter into pay-fixed swaps at any rate reset date over the next 12 months
exactly offsetting the existing swaps in the portfolio and locking in a loss of $4.5 million.
Alternatively the options could be cash-settled. The cap premium can be paid upfront or
on a periodic basis.
Recovery rate
The percentage of par paid to creditors after a default. This is an important concept in credit
derivatives because it can dictate the pricing and structure of a number of products.
Example
One bank is willing to take exposure to a credit at the senior unsecured level at a spread of
40bp. Another bank with this existing exposure is willing to sell this exposure at the same
spread. However, the first bank considers the likely recovery rate for the credit to be 50%
while the second thinks that it is 70%.
The two institutions may enter into a credit swap in which the contingency payment is fixed
at 50%, rather than at the floating recovery rate of senior unsecured debt as determined by
dealer poll. The second bank, the protection buyer, is prepared to pay up to 40 x 50/30 bp
(67bp) for the fixed recovery contract since it offers more protection than the floating
recovery contract given the bank’s recovery rate expectation of 70% (50/30 is the ratio of
expected losses in the fixed versus floating recovery transaction). Conversely, the first bank
is happy to receive any premium over 40bp for the 50% fixed recovery transaction since in
its view this is equivalent to the floating recovery transaction. A transaction completed at,
say, 55bp, would leave both institutions happy given their divergent recovery rate views.

12. Reference asset
The underlying assets on whose price or status a credit derivative is based. Reference assets
can take almost any form including government bonds, Brady bonds, Eurobonds, MTNs,
loans,.letters of credit, trade receivables, receivables due under derivative agreements,
CBOs, mortgages, indices and funds.
Sovereign risk guarantee [option]
An option that gives the holder the right to demand delivery of a pre-determined amount
of hard currency to a bank account in a country with no exchange controls in exchange for
the local currency of a particular sovereign at the prevailing exchange rate in the event of
a pre-determined credit event. This event is usually defined in terms of foreign exchange
controls or non-convertibility.
Sovereign risk guarantees are used to hedge a counterparty’s business risk in a country
rather than investment risk in a security. Countries can suspend foreign-exchange
convertibility without defaulting on any specifiable reference asset. This makes credit
swaps imperfect hedges against many forms of sovereign risk. Even though the imposition
of currency controls would likely lower any sovereign borrower’s credit standing in
investors’ eyes, which would increase the value of a credit swap, the basis risk would be
too large to make the hedge usable. The sovereign risk guarantee lets the protection buyer
transfer money out of a country even if it has declared non-convertibility or non-
transferability.
The protection seller may simply be an institution that wishes to be paid a premium for
assuming non-convertibility risk. However they can also be entities such as local banks or
local or foreign corporates who need local currency regardless of convertibility. In
particular, corporations that have entered into joint venture agreements that specify local
investment at specified future dates could write sovereign risk options against an
underlying position to gain a premium.
The options are priced off the sovereign’s outstanding hard currency obligations of the
same tenor as this is the investment alternative and carries equivalent risks. The option will
be more expensive because it is illiquid. Transaction sizes typically range between USD5
million and USD20 million with tenors up to 12 months. These products are almost always
embedded in short-dated credit-linked limited recourse notes. These are denominated in
hard currency but pay out in local currency if specified credit events occur (see chapter
16).

13. Structured repo
Flexible repo agreements that create financing and investment vehicles that are more
efficient than those available in the traditional repo market. Investors can use cancellable
repos and convertible repos to set initial financing rates well below those available on the
plain vanilla market. They can also achieve better risk-adjusted returns by using reverse
structured repos to hedge credit risk on emerging market bonds.
Example
An investor can achieve collateralized above-market, double-A rated returns using a
reverse structured repo to finance a single-B rated Ecuadorian sovereign bond for a
double-A rated bank counterparty. The investor pays cash for the bond at the trade date
and at maturity it resells the bond to the bank at par. In the interim the investor holds the
bond on its balance sheet for a year and earns superior risk-adjusted returns by
exchanging the credit risk of the single-B rated bond for the double-A rated counterparty
risk of the bank counterparty.
Swap guarantee
A credit swap whose notional principal is adjusted in line with the mark-to-market value
of a reference swap (or other market sensitive instrument) and with a contingent payment
triggered by default on that swap. The main use of these products is to manage credit risk
in cross-currency swap portfolios.
The problem swap counterparties face is that the projected exposure on a swap can vary
enormously throughout the life of a swap. Take a 10-year $100 million notional yen/dollar
currency swap with principal exchange initiated in May 1990. At inception, prevailing rates
implied a maximum exposure at maturity of $125 million. five years later, as the yen
strengthened and interest rates dropped, that maximum exposure had risen to $220 million.
Three years’ later and it has fallen again by almost $100 million. This exposure is
exacerbated if the counterparty’s credit quality is correlated to the level of the yen and/or
to interest rate movements. A lender in a currency that has experienced depreciation and
rising interest rates will be out of the money on the swap and could be a weaker credit.
The swap guarantee hedges the exposure between margin calls on collateral posting.
Alternatively it can be structured to cover any loss beyond a pre-agreed amount. The buyer
will only incur default losses if the swap counterparty and the protection seller default. This
means that the credit quality of the buyer’s position is compounded to a level better than
the quality of either of its individual counterparties.
Switch[able] asset swap
An asset swap in which the buyer sells a counterparty (usually the dealer from whom the
asset swap was bought) the right to substitute the underlying asset with another asset (or
any one of a basket of pre-specified assets) on particular dates usually at a spread higher
than the prevailing market level. The embedded option is a spread option between the

14. substitutable securities.
At the initiation of the transaction all the underlying assets will be of the same duration and
credit quality and so ought to move together in price with changes in interest rates. The
main reason for any spread change is therefore due to a change in perceptions of credit
quality. The counterparty exercises his option to substitute if one of the basket declines in
credit standing versus the asset that is asset swapped at the beginning of the transaction.
These swaps are used to enhance the yield of vanilla asset swaps. Also known as a basket
asset swap. See basket credit spread option.
Example
An investor with a funding cost of Libor+10bp wants to buy an asset swap trading at
Libor+10bp. It sells an option under which it agrees to deliver the Libor+10bp asset to the
counterparty in return for another asset. This asset is either the cheapest to deliver from a
basket or is a pre-specified security. In the latter case, the counterparty can deliver the new
asset at a spread 15bp worse than the prevailing market level. The premium received for
the sale of this option is 10bp. The investor receives enhanced yield in return for the credit
risk on the new asset. The option buyer has hedged for less than the cost of a standard
default swap.
Total return swap
An agreement that allows a counterparty to transfer the total economic risk both credit risk
and market risk of an underlying asset or portfolio of assets to another counterparty without
transferring the asset itself. (A default swap transfers only credit risk to the counterparty.)
The holder of an asset wishing to hedge exposure to that asset pays the total return (all
interim cash flows and any change in positive mark-to-market value) of a reference asset
and (usually) receives Libor plus a fixed spread and any capital depreciation from the other
counterparty. Price appreciation or depreciation may be calculated and exchanged at
maturity or on an interim basis. Total return swaps can be cash settled on the basis of a
final mark-to-market value of through physical delivery at maturity in which case the total
return receiver pays the previous mark-to-market price of the asset or portfolio in exchange
for the actual securities. Eligible assets are those with liquidity and observable prices.
Pricing depends on a number of factors: the cost of funds for the short counterparty; balance
sheet constraints the short counterparty may have the assets on its balance sheet with the
associated capital charges; credit risk both the riskiness of the asset as well as that of the
long counterparty are considered. Several methods can be employed to mitigate the risk of
the transaction including triggered collateral accounts, up front buffer collateral accounts
and daily mark-to-market.
As with the credit default swap there is no exchange of principal and ownership and
funding of the underlying asset is unchanged. If the swap maturity matches that of a
reference loan or bond asset it is simply a synthetic version of the bond or loan that allows
the holder to go long or short easily and without funding. If it is not, then the swap is a

15. synthetic asset that may not exist in the market.
Total return swaps can be structured on all the same asset classes as other derivatives. They
are used by investors to go long or short securities or instruments that are difficult to obtain,
that they cannot purchase in the form in which they are traded in the cash market or whose
form is too complex for them to analyze. They also offer unfunded so leveraged exposure
to the underlying. Total return receivers lock in term financing rates and total return payers
effectively sell an asset without ownership having changed hands. This makes them
analogous to repurchase agreement and some banks characterize certain types of repos for
example those on emerging market debt as credit-linked total return swaps. The main
difference is that in a total return swap the underlying securities are not exchanged whereas
in a repo transaction they are. This transfer of economic benefit without effecting a legal
sale of the underlying asset can be advantageous for capital gains tax reasons. (See
structured repo.)
Total return swaps are also used by banks to keep assets off their balance sheets. Instead
of borrowing to fund the purchase of assets, a bank that wants exposure to a particular asset
enters into a total return swap with a counterparty (sometimes called the warehouse or
balance sheet provider) willing to buy the bonds. The balance sheet provider a bank or
large corporate effectively funds the position of the investing bank which then pays the
funding costs to them and receives a spread. If the originator of the transaction is itself
balance sheet constrained, such as an investment bank, then it will buy the underlying
bonds and then repo them out to the final balance sheet provider.
Example
An investor seeks exposure to a loan yielding libor + 350 basis points that a double-A rated
bank has made to a Turkish corporation. The investor enters into a total return swap with
the bank the total return payer under the terms of which it pays three-month Libor +100
basis points and receives Libor + 350 basis points plus or minus any change in the market
price of the loan. If the loan’s market value remains unchanged over the life of the contract,
then the investor earns 250 bp on the transaction. However the investor bears both the price
risk and any early repayment risk on the loan over the life of the agreement.