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FRM Part II · FRM Exam Part II · Credit Derivatives

A fund manager wants exposure to a corporate bond's credit spread, receiving the bond's total return (coupons plus price changes) and paying LIBOR plus a spread, without buying the bond. Which instrument does this describe, and what key risk does it add compared with a CDS?

This is a total return swap. The receiver gets the bond's coupons and price changes and pays a floating funding rate plus spread. Unlike a CDS, which pays only on a credit event, the receiver suffers losses from any price decline, including spread widening, even without default.

  1. ATotal return swap; the receiver bears market-price losses even without a defaultCorrect
  2. BCredit-linked note; the receiver bears the issuer risk of the swap dealer only
  3. CAsset swap; the receiver is protected against price declines
  4. DCredit spread option; the receiver has no downside beyond a premium

Explanation

In a total return swap the receiver gets all coupons and price appreciation and pays any depreciation, plus funding at LIBOR plus spread. Thus losses arise from spread widening or rate moves even with no default, unlike a CDS that pays only on a credit event. The other options describe different instruments or wrongly claim protection.

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