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Lets assume for the sake of the example that we are talking about a Total Return Swap. The flow diagram is something like this.

enter image description here

Lets assume the Payer in this instance is a Hedge Fund, and the Receiver another Hedge Fund.

Since the assets are never sold, but rather remain in possession of the Payer how does the "accountability" process take place. In other words, how does the total receiver know that the reference asset gains that he is receiving are in fact accurate, or, that in the case of a credit event, he can verify that the spread he gets requested to pay-out is also accurate.

It would be massively helpful to have a breakdown of the various stakeholders and interactions when executing in practice a TRS.

Apologies if the question is quite broad, i am new to all of this.

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A TRS is very rarely between Hedge fund 1 and Hedge fund 2 (how would they find each other?). Much more likely that it is between Hedge Fund 1 and a Dealer. In the latter case, one of the counterparties must act as Calculation Agent, and it is almost always the Dealer. The Calculation Agent has the responsibility of marking to market the asset, for the purposes of determining the cashflows that you have described. Often , the Hedge Fund has "dispute rights" that enable it to challenge the actions of the Calculation Agent. These Dispute Rights might specify that the Hedge Fund can appeal to a panel of 5 banks to determine the asset value, for example. The result of this poll would be legally binding.

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  • $\begingroup$ Hedge Fund_1 and Hedge Fund_2 is just for illustration purposes, as requested by the OP. As an OTC instrument, nothing prevents a financial institution to find and match the interests of 2 of its Hedge Fund clients although it might not be a general practice. $\endgroup$ – owner Dec 7 '15 at 19:51
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In general any OTC trade (in your case total return swap) between two parties (i.e. buyer - Party A and dealer - Party B) shall and would be driven off a legal document which sets out transaction details. In most of the cases such legal document would be ISDA Master agreement and it's annexes (if any). There should be a notion/definition of a "Calculation Agent" who would compute and determine amounts. Usually Calculation Agent would be Party B (dealer). As for the actual amounts itself - it would depend on the underlying asset, i.e. if it's a listed security then Party A (buyer) could easily verify amounts and question Party B if unable to reconcile.

Have a look at a template Master Bond Total Return Swap Derivatives Confirmation Agreement and you'll grasp an idea on who and how computes the amounts.

Hope this helps

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Interesting question, and let's briefly start with a conventional definition of Total Return Swap (assuming the reference asset is a stock index). As a matter of fact a TRS is an agreement to exchange the total return (dividends + capital gains) realized on a stock index for either a fixed or a floating rate of interest (e.g LIBOR, LIBBOR + spread (in basis points)) as very-well summarized in your picture. Both exchange of cash flows between the Fixed-leg Payer and the Floating-leg Payer being applied on the swap notional amount.

*For concreteness purposes, it's worth adding an additional stakeholder (Broker), thus the parties in a TRS generally involve:

1- Hedge Fund_1 (as requested)

2- Hedge Fund_2 (idem)

3- Prime Broker , holding the reference asset (e.g proprietary index, etc.) and also generally acting as a Counterparty of the trade.

**In an attempt to avoid any Informational Asymmetry, Moral Hazard, etc., the Broker (e.g Custodian Bank) is performing the computations (compute Index levels, Returns, at time t, mostly for proprietary indexes) and disclose it (on its website or on request) for transparency purposes while valuing the swap (Mark-To-Market) in accordance with the terms of the contract/agreement stipulated in the Swap Term Sheet. For instance it could be stated in the Term Sheet that Hedge Fund_1 pays 15 basis points or LIBOR + 10 bp to Hedge Fund_2 if:

The Index level is > a defined threshlod (yesetrday's value),

Otherwise receive from Hedge Fund_2 the return at t on the index.

The latter document could be obtained on request from the Counterparty of the trade, if neither Hedge Fund_1 nor Hedge Fund_2 has their own copy internally. It's worth stating that these agreements have legal implications, thus are generally signed by all the parties.

Ps: Mark-to-Mark value of the swap is also disclosed in the Net Asset Value (NAV) file sent frequently by the Fund Administrator to the Hedge Fund Managers (Hedge Fund_1 or Hedge Fund_2).

**In the case of Credit Derivatives, the Reference Asset is usually iTraxx, but the above logic applies as well.

Hope it helps

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