Quiz: OTC Products

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2 questions to check your understanding of the chapter “OTC Products”. Choose an answer and select “Check answer” to see the answer and explanation. You can also open “Answer and explanation” to see the answer first.

1. Question 1

   As a hypothetical example, an asset manager receives the equity return in a total return swap (TRS) on 200,000 shares. The share price at the start is 5,000 yen, the notional amount is 1 billion yen, the interest is a floating rate of 2.00% a year plus a spread of 0.50% a year, and the term is 3 months (0.25 years). After 3 months the share price is 4,800 yen, and the dividend is 50 yen a share, paid at the end of the period. What is the asset manager's net payment or receipt?

   1. A.A payment of 56.25 million yen
   2. B.A payment of 30 million yen
   3. C.A payment of 23.75 million yen
   4. D.A payment of 36.25 million yen
   Answer and explanation

   Answer: D

   The net amount is a payment of 36.25 million yen. The equity side adds the price change and the dividend amount. The price change is (4,800 − 5,000) × 200,000 shares = −40 million yen. The dividend amount is 50 yen × 200,000 shares = 10 million yen received. The interest side is 1 billion yen × (2.00% + 0.50%) × 0.25 = 6.25 million yen paid. The net is −40 million yen + 10 million yen − 6.25 million yen = −36.25 million yen. A TRS on a stock is also called an equity swap.

   A payment of 56.25 million yen is the value when the dividend amount is subtracted as a payment instead of received. A payment of 30 million yen is the value when the interest is not subtracted. A payment of 23.75 million yen is the value when the interest is treated as received and 6.25 million yen is added.

   Suppose instead that the share price had risen to 5,200 yen after 3 months. The price change would be (5,200 − 5,000) × 200,000 shares = 40 million yen received. With the same dividend and interest, the net would be 43.75 million yen received.

   Learn more: Equity Swaps and Total Return Swaps

2. Question 2

   A bank takes the side paying the equity return in a trade with an asset manager that exchanges the equity return and interest (a TRS). When entering into the trade, the bank hedges by buying the underlying shares for the same amount as the notional amount. When the share price falls, what is the combined result of the bank's loss on the shares and its payments on the TRS?

   1. A.They do not offset, and the loss on the fall in the shares remains
   2. B.The amount received on the TRS is larger than the loss on the shares, so a profit results
   3. C.They offset each other, and the interest received from the asset manager remains
   4. D.They offset each other, and a loss remains equal to the interest paid to the asset manager
   Answer and explanation

   Answer: C

   They offset each other, and the interest received from the asset manager remains. A dealer on the side paying the equity return usually hedges by buying the underlying shares. When the price falls, the shares the bank holds lose value, and the bank receives the same amount as the price fall from the asset manager. The loss on the shares and the amount received on the TRS are equal, so they offset each other, and the bank is left with the interest. When the price rises, the direction reverses: the gain on the shares held offsets the price rise paid to the asset manager. The bank uses this interest to cover the cost of funding the shares it holds.

   The choice saying they do not offset ignores the price fall received from the asset manager. The choice saying a profit results treats the amount received as larger than the loss on the shares, but the two are equal. The choice saying the bank pays interest has the direction of the interest reversed, because the bank is the side that receives it.

   Learn more: Equity Swaps and Total Return Swaps