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Offered on attractive terms so far.
The total return swap market has been a key financial market innovation. It gives portfolio managers new freedom by allowing them to reduce the costs associated with either obtaining exposure to a market sector or hedging an exposure. For private commercial real estate equity, there is now a new swap product based on the NCREIF Property Index, yet to be tested in the market (see Fisher [2005]).
For commercial mortgage-backed securities (CMBS), several dealers offer swaps on various CMBS indexes and their subsectors. We describe these CMBS swaps and their mechanics, and address the economic rationale as to why the market has offered attractive terms to those who want exposure to a CMBS sector.
TYPES OF CMBS TOTAL RETURN SWAPS
In a total return swap (TRS), one party makes an interest payment to a counterparty in exchange for the total return realized on a reference asset. The total return of a reference asset includes all cash flows that are thrown off by the asset as well as the capital appreciation or depreciation of the reference asset. The interest payment is generally a floating rate based on a reference rate (typically LIBOR) plus or minus a spread.
The party that agrees to make the floating-rate payments and receive the total return is referred to as the total return receiver or the swap buyer, the party that agrees to receive the floating-rate payments and pay the total return is referred to as the total return payer or swap seller. The reference asset could be a credit-risky bond, a loan, a reference portfolio consisting of bonds or loans, an index representing a sector of the bond market, or an equity index.
One can think of a TRS as composed of two legs: 1) the long leg, and the 2) financing leg. The long leg is economically equivalent to a long (ownership) position in the reference asset for the TRS; the financing leg is the cost of acquiring that position. Thus, from the perspective of the total return receiver, a TRS is a leveraged position in the reference asset. The receiver achieves the same economic effect as it would if it borrowed money and used those funds to purchase the reference asset....