Valuation of Fixed Income Total Return Swaps
Abstract: A total return swap is a swap in which one party makes periodic floating rate payments to a counterparty in exchange for the total return realized on a reference asset (or underlying asset). The reference asset could be a credit-risky bond, a loan, a reference portfolio consisting of bonds or loans, an index representing a sector of the bond market, or an equity index. A total return swap can be used by asset managers for leveraging purposes and/or a transactionally efficient means for implementing a portfolio strategy. Bank managers use a total return swap as an efficient vehicle for transferring credit risk and as a means for reducing credit risk exposures. The Duffie-Singleton model can be used to value total return swaps.
In this entry we explain the valuation of total return swaps.1 We begin with an intuitive approach.
AN INTUITIVE APPROACH
A typical total return swap is to swap the return on a reference asset for a risk-free return, usually the London Interbank Offered Rate (LIBOR). The cash flows for the swap buyer (that is, the total return receiver) are shown in Figure 1. In the figure, Lt is LIBOR at time t, s is the spread to LIBOR, and Rt is the total return at time t. The cash outlay at time t per $1 of notional amount that must be made by the swap ...