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FRM Part I · FRM Exam Part I · Credit Risk Transfer Mechanisms

In a total return swap on a bond, the total return payer (the bank) transfers the bond's economic performance to a counterparty. Which statement correctly describes the bank's position?

The bank, as total return payer, pays the bond's coupons and price appreciation and receives a floating rate plus payments for any price depreciation. This transfers both credit and market price risk, unlike a CDS which pays only on a credit event.

  1. AIt receives any price appreciation on the bond and pays coupons and depreciation
  2. BIt pays the bond's coupons and price appreciation and receives a floating rate plus compensation for price depreciationCorrect
  3. CIt pays only when the bond issuer defaults
  4. DIt transfers credit risk but keeps all market price risk

Explanation

The total return payer passes on coupons and price gains and receives a reference rate (e.g., SOFR plus spread) plus payments covering price declines. This transfers both credit and market risk, unlike a CDS that pays only on a credit event. The first option reverses the direction.

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