QUESTION $4.$

$4\mathrm{.}1)$ Explain the framework of total return swaps $($TRS$).$ While entering a credit swap does not eliminate credit risk entirely, would entering a TRS do so$?$ Justify your answer.

$4\mathrm{.}2)$ A bank has made a loan of USD $300$ million at $7\%$ per annum. The bank enters into a total return swap under which it will pay the interest on the loan plus the change in the marked$-$to$-$market value of the loan, and in exchange the bank will receive LIBOR $+50$ basis points. Settlement payments are made annually. Illustrate the swap in a relevant diagram. What is the cash flow for the bank on the first settlement date if the mark$-$to$-$market value of the loan falls by $2\%$ and LIBOR is $4\%?$

$(15\%)$

$4\mathrm{.}3)$ Discuss the difference between Credit Default Swap and Total Return Swap in terms of hedging market risk. Properly define all relevant concepts. When an institution sells exposure to another institution $($i$.$e$.,$ purchases protection$)$ in a CDS$,$ it exchanges the risk of default on the underlying asset for which type of risk? Explain how this second type of risk is reflected in the CDS spread.

$(20\%)$