The latest additions to the family of derivatives are those relating to an underlying credit exposure. The Bank of England defines credit deriva­ tives as follows:

"Credit derivatives!" is a basket term used to describe various swaps arlCl opilOfl COYllrQClS dCSISLYICU lO uSSUTYlC or lay OJJ crCQ.ll

They are a natural extension of the market for products that unbun­ dle risk (such as interest rate swaps), allowing banks to transfer credit exposure in isolation from other forms of risk on any underlying trans-

Total return swap A Total Return Swap transfers the total economic performance of a ref­ erence asset, including all associated cash flows as well as capital appreciation or depreciation. The total return payer pays all contractual payments plus any price appreciation on the reference asset in return for a negotiated floating rate plus any depreciation on the reference asset. For example, Bank A may agree to a total return swap with Bank B linked to a bond issued by XYZ Corporation. The terms of the agree­ ment might be such that Bank A receives periodic payments equal to any positive mark-to-market movements in the price of the bond (including any coupon payments) and in return makes payments to Bank B equal to any negative movements in the price together with

Libor plus a spread. Figure 20.1 illustrates these arrangements.