Understanding corporate finance: derivative contracts: using derivatives to manage risk: total return swaps
A total return swap, in accounting terms, is a swap that exchanges the total return on a defined portfolio for, say, 3-month LIBOR plus or minus margin on a notional principal amount that matches the opening value of the portfolio.
Total return swap: example
Umbron plc is a commercial bank, which holds bonds with a nominal value of £100 million and a 3-year maturity, paying a fixed rate of interest, issued by a major UK group. The group’s credit rating is currently A+, but if the creditworthiness of the group declines, the fair value of the bonds (which Umbron plc is marking to market in its accounts) will decrease, with a consequential impact on the bank’s balance sheet and profits. Conversely, of course, Umbron plc will profit if the bonds increase in value.
The bank enters into a total return swap with an investment bank, Voltra Bank plc. Under the terms of the swap Umbron plc pays Voltra plc the ‘total return’ - interest plus capital growth - from the bonds. This means that, at the end of each quarter, Umbron plc pays over an amount equal to:
- the interest coupon on the bonds, plus
- any growth in the capital value of the bonds.
If the bonds decline in value, then Voltra Bank plc will make a payment to Umbron plc. So, for example, if the capital value of the bonds varies as follows:
|Start of swap||£99m|
|End of quarter 1||£94m|
|End of quarter 2||£95m|
|End of quarter 3||£97m|
then Umbron plc will
- receive £5 million at the end of the first quarter,
- pay £1 million at the end of quarter 2, and
- pay £2 million at the end of quarter 3.
(It must, of course, also make payments equivalent to the interest received on the bonds at the end of each quarter.)
In return, Voltra Bank plc pays a floating rate of interest (calculated on the nominal value of the bonds, £100 million) at, say, LIBOR plus 0.1%.
The effect of the arrangement is that Umbron plc can show the bonds in its accounts at a fixed capital value: £99 million. In addition, it receives a LIBOR-linked income stream.
There is a downside and an upside for Voltra Bank plc. The downside is that Voltra Bank plc has assumed the credit risk on the bonds. The upside is that it now also has exposure to the potential rewards of owning the bonds, without having to put up the capital to actually buy the asset.