HW_8a__Answers_Solutions - ANSWERS TO HOMEWORK QUESTIONS -...

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ANSWERS TO HOMEWORK QUESTIONS - HW #10 8. Explain how a total return swap can be used by a portfolio manager to effectively short corporate bonds. A total return swap can be used by a portfolio manager to effectively short corporate bonds by being a total return payer and receiving a floating payment. More details are given below. Credit derivatives are used by bond portfolio managers in the normal course of activities to more efficiently control the credit risk of a portfolio and to more efficiently transact compared to using the cash market. For example, credit derivatives allow a mechanism for portfolio managers to more efficiently short a credit-risky security than by shorting in the cash market, which is often times difficult to do. An investor who wants to short the corporate bond will find it difficult to do so in the corporate bond market because the bond markets are illiquid and there are not enough parties to provide for shorting bonds. However, an investor can short bonds efficiently by using a total return swap. In this case the investor will use a total return swap in which it is a total return payer and will receive a floating payment By being a total return payer, a portfolio manager pays all corporate bond coupon cash flows as well as the capital appreciation or depreciation of the bonds. 9. Why is the total return receiver in a total return swap exposed to more than just credit risk? The party that agrees to make the floating payments and receive the total return is referred to as the total return receiver. The party that agrees to receive the floating payments and pay the total return is referred to as the total return payer. In a total return swap, the total return receiver is exposed to both credit risk and interest rate risk. For example, the credit risk spread can decline (resulting in a favorable price movement for the reference obligation), but this gain can be offset by a rise in the level of interest rates. More details on the exposure to interest rate risk are given below. Suppose a portfolio manager's expectations are realized and there is a decline in the credit spread. However, this does not guarantee that the portfolio manager will make a net outlay. This is because of a disadvantages of a total return swap, which is that the return to the investor is dependent on both credit risk (declining or increasing credit spreads) and market risk (declining or increasing market rates). Two types of market interest-rate risk can affect the price of a fixed income asset. Credit-independent market risk is the risk that the general level of interest rates will change over the term of the swap. This type of risk has nothing to do with the credit deterioration of the reference obligation. Credit-dependent market
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This homework help was uploaded on 02/20/2009 for the course AEM 4260 taught by Professor Bogan,v. during the Fall '06 term at Cornell University (Engineering School).

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HW_8a__Answers_Solutions - ANSWERS TO HOMEWORK QUESTIONS -...

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