What it means
In a typical arrangement a bank holds a bond or a basket of shares and agrees to pass on everything that asset earns to a counterparty, known as the total return receiver. The receiver pays a floating interest rate plus a spread on the notional amount, which is the reference size of the deal rather than money actually exchanged at the start.
The structure appeals to both sides for different reasons. The receiver gains exposure with little upfront cash, which creates leverage, while the payer keeps the asset on its books but transfers the risk of price falls and the benefit of price rises.
Businesses outside financial markets rarely enter these contracts directly, but they meet them indirectly through fund managers, pension schemes and structured financing arrangements. Understanding the mechanics matters because the risk sits with the receiver even though the asset never appears in its name.
The main hazard is counterparty risk, the possibility that the other side fails to pay what it owes. Losses can also exceed the cash committed, because the receiver owes any fall in value on the full notional amount, not just on the margin it has posted.
A total return swap differs from a credit default swap in an important way. A credit default swap pays out only on a defined credit event such as a default, whereas a total return swap transfers the entire performance of the asset, including ordinary price movement.
In practice
Real-world examples.
Example
A pension fund wants exposure to an emerging market bond index but cannot open custody accounts in every country involved. It enters a total return swap with a global bank and receives the index return while paying a floating financing rate.
Example
A bank holding a large block of loans wants to reduce its exposure without disturbing customer relationships. It pays away the total return on the portfolio to a hedge fund, keeping the loans on its books and its client contacts intact.
Example
An asset manager uses a total return swap to gain exposure worth $200,000,000 while posting $20,000,000 of collateral. The position gives it ten times the exposure of its cash outlay and a matching multiple of the risk.
Think of it
“Total return swap gives you all the gains and losses of an asset-without actually owning it.
Formula
Calculation
Net payment to the total return receiver = (income received + change in market value) - (financing rate x notional amount).
A fund enters a one year total return swap on a $50,000,000 corporate bond portfolio. Over the year the portfolio pays $2,000,000 of interest and rises in value by $1,000,000, so the total return is $3,000,000, equal to 6% of the notional.
The fund pays a financing rate of 5.2% on the notional, which is $50,000,000 x 5.2% = $2,600,000. The net settlement in the fund's favour is $3,000,000 - $2,600,000 = $400,000. Had the portfolio instead fallen 2% in value, the fund would have owed the $1,000,000 loss plus the $2,600,000 financing charge less the $2,000,000 of interest, a net payment of $1,600,000.Case study
Seen in the real world.
The following is a fictional and illustrative scenario. Vantris Capital, an invented mid sized investment firm, held $60,000,000 of client capital and wanted exposure to a portfolio of listed infrastructure shares without the administrative burden of holding stock in nine jurisdictions.
Vantris entered a total return swap with a fictional counterparty on a $180,000,000 notional, posting $30,000,000 of collateral. In the first year the reference portfolio returned 9%, the financing cost was 5%, and the net gain of $180,000,000 x 4% = $7,200,000 looked outstanding against the collateral committed.
In the second year the portfolio fell 7%. Vantris owed $12,600,000 of losses plus financing, wiping out the prior gain and forcing a collateral call it could only meet by selling other holdings. The illustrative lesson is that the leverage which flatters returns in a good year is the same leverage that magnifies the bad one.
Watch out
Common mistakes.
- Believing the receiver has no exposure because it does not own the asset, when it carries the full economic risk of every price movement.
- Sizing the position against the collateral posted rather than against the notional amount, which understates the real risk by several times.
- Treating a total return swap as equivalent to a credit default swap, when only the latter is triggered by a specific credit event.
Questions
People also ask.
Does money change hands at the start of a total return swap?
Usually not beyond collateral, since the notional is a reference figure rather than a sum transferred.
Who typically acts as the payer?
Banks and other institutions that already hold the asset and want to transfer its risk while retaining ownership.
Are these contracts reported on the balance sheet?
They are recorded at fair value as derivatives, with the notional amount disclosed in the notes rather than shown as an asset.
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