Question

Peter, a bond fund manager, would like to transfer the credit risk of the 4 year BIM corporate bonds with a notional 10M. He meets Ben, an equity fund manager, who wants to transfer the price risk of GOS stock with a notional 10M. Peter and Ben agree to form a Total Return Swap for risk reduction. The bond is paying a return 7% per year. Draw the swap with the payments for all the parties.

Answer 1

Swap refers to a derivative contract where one party exchanges their cash stream or any liability with another party to hedge their respective risks. In this question, Ben and Peter are exchanging their respective returns through a swap contract, to illustrate; following is the exchange that happens for 4 years till the BIM corporate bond matures.

Please note, this is not an exchange of the underlying asset, only exchange of cash flow.