What are the differences between excess return swap and total return swap? Also the principal amount in excess return swap is notional or actual?
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Think like this :
Excess Return Swap = A series of Call Options
Total Return Swap = Futures
Excess Return Swap :
Suppose, an oil refiner, goes long a swap that pays the amount exceeding $100 per barrel every month. The oil refiner would pay a swap counterparty a premium (say, $38) for this privilege because it is effectively long a series of call options.
That’s the structuring of an Excess Return Swap: Payoff = Max(S-100, 0); Profit = Payoff – Premium paid for the Excess Return Swap
Now, say Oil Price at Month 1 to 12 = 108, 110, 120, 140, 90, 80, 110, 100, 90, 90, 120, 110; So, accordingly, the payoff of the Oil Refiner = 8, 10, 20, 40, 0, 0, 10, 0, 0, 0, 20, 10.
Total Payoff = ( 8+10+20+40+0+0+10+0+0+0+20+10) = 118
Profit to the Oil Refiner = 118 – 38 = $80
Total Return Swap
In a total return swap, the change in the level of the index will be equal to the returns generated by the change in the price of each of the futures contracts that comprise the index plus a return based upon interest earned on any cash collateral posted upon the purchase of the futures contracts comprising the index. If the level of the index increases, the swap buyer receives payment net of the fee paid to the seller; if the level of the index decreases between two valuation dates, the swap seller receives payment (plus the fee charged to the buyer).
As an example of a total return swap, assume an investor who manages a defined benefit retirement plan desires commodity exposure for the reasons noted earlier. Given the size of the portfolio manager’s plan assets (assume £2 billion), the manager is seeking approximately 5% exposure of plan assets to commodities. More specifically, the manager has decided that this £100 million exposure (5% of £2 billion) should be to the (hypothetical) China Futures Commodity Index (CFCI) and should remain for five years. Based on this decision, the manager issues a request for proposals (RFPs) and, after evaluating the various bidders, contracts with a Swiss bank for a total return swap that will provide the desired exposure.
If on the first day of the swap agreement the CFCI increased by 1%, then the swap dealer would owe the manager £1 million (£100 million × 1%). If on the second day the CFCI declined by 5%, then the manager would owe £5 million to the dealer.