Credit Risk Management Practice Exam

Which of the following best describes a total return swap?

1. It exchanges a debt obligation for a fixed interest rate

2. It provides returns from a debt obligation in exchange for specified payments

3. It guarantees capital preservation on investments

4. It is an investor's contribution to a mutual fund

The correct answer is: It provides returns from a debt obligation in exchange for specified payments

A total return swap is a financial derivative contract where one party exchanges the total return of an asset—typically a debt obligation—for specified cash flows, often represented by a fixed or floating interest rate. The term "total return" refers to the overall return on the asset, which includes both the income received from the asset (such as interest payments) and any capital gains or losses on the asset's value. In this type of transaction, one party gains exposure to the asset's total return without actually owning the asset itself, while the other party receives steady income payments. This arrangement allows parties to manage their risk exposure, enhance yield, or leverage investments without affecting their balance sheets directly. The other choices do not accurately capture the essence of what a total return swap represents. For instance, exchanging a debt obligation for a fixed interest rate does not reflect the return on the asset itself, and guaranteeing capital preservation or being an investor's contribution to a mutual fund does not pertain to the complexities and functionalities of a total return swap. Thus, the description that focuses on exchanging the total return of a debt obligation for specified payments captures the fundamental nature of a total return swap accurately.