What it means
In a total return swap, there are two sides. The total return payer owns, or references, an asset such as a bond, a loan or a share index and pays all its returns to the other side, called the total return receiver.
The receiver in turn pays a floating rate (a rate that moves with a benchmark) plus a spread, which acts like financing cost. The returns passed on include any interest or dividends and any change in the asset's value over the period.
If the asset falls in value, the receiver must pay that fall to the payer, so the receiver carries the loss as though it owned the asset. The main attraction is leverage, meaning exposure to a large asset for a small amount of cash.
The receiver may need to post only some collateral (assets pledged as security) instead of the full purchase price. The risk is that losses can be large relative to the collateral, and the receiver may face margin calls (demands for more collateral) if the asset falls.
The payer, often a bank, uses the swap to remove the asset's risk from its books while still holding the asset, which can ease capital requirements. For the receiver, the swap can offer access to markets or assets that are hard to buy directly, or a way to take a short view by taking the opposite side.
Counterparty risk is the key nuance. Each side relies on the other to pay, so the contracts specify collateral and netting terms, and the legal treatment varies by jurisdiction.
In some contexts, TRS could also stand for other things, such as a teachers' retirement system, so the context must be checked. Anyone trading these contracts should read the master agreement and the collateral terms with a lawyer.
Valuation disputes, early termination and changes in the reference asset are the clauses that most often cause friction.
In practice
Real-world examples.
Example
A hedge fund wants exposure to a basket of leveraged loans but does not want to fund the purchase. It enters a total return swap with a bank, posts collateral of 15% of the notional amount and receives the loans' returns.
Example
A bank holds a corporate loan to a client and wants to reduce its risk without telling the client. It enters a swap in which an investor receives the loan's returns and takes the credit losses.
Example
A pension fund uses a total return swap on an equity index to gain market exposure quickly while its cash is tied up in other assets for a few weeks. It unwinds the swap when the cash is released.
Formula
Calculation
Total return = Income received + Change in asset value
Net payment to receiver = Total return on the asset - Financing payment
A hedge fund enters a quarterly total return swap on a bond portfolio with a notional amount of $10,000,000. Over the quarter, the portfolio pays $150,000 of interest and rises in value by $200,000, so the total return is 150,000 + 200,000 = $350,000.
The fund pays a financing rate of 5% a year, which for one quarter is 10,000,000 x 0.05 / 4 = $125,000. Its net receipt is 350,000 - 125,000 = $225,000. If the portfolio had instead fallen by $500,000, the fund would owe 500,000 - 150,000 + 125,000 = $475,000, because it pays the loss and the financing cost, less the interest received.Case study
Seen in the real world.
Lionheart Credit Partners is an illustrative, fictional fund that used a total return swap to gain $50,000,000 of exposure to corporate bonds. It posted $7,500,000 of collateral, which was 15% of the notional amount.
When bond prices dropped by 6%, the fund owed $3,000,000 on the price decline, and the dealer asked for extra collateral. The fund had kept a cash reserve and met the call, but a smaller fund with no reserve might have been forced to sell other holdings.
The illustrative lesson is that the leverage cut both ways. Lionheart rewrote its risk policy to cap swap exposure at three times its cash reserve, and required daily reporting of margin calls to the investment committee.
Watch out
Common mistakes.
- Believing the receiver does not bear the asset's losses, when the receiver pays any fall in value in addition to the financing cost.
- Ignoring counterparty and margin risk because no asset has been bought.
- Assuming all TRS contracts are the same, when the reference asset, term and collateral terms are negotiated one by one.
Questions
People also ask.
What is the difference between a TRS and owning the asset?
The receiver gets the economic return but not legal ownership, so it has no voting rights or direct claim on the asset.
Why do banks offer total return swaps?
They earn a fee or spread, and the swaps let clients take exposure while the bank manages its balance sheet.
Is a total return swap a derivative?
Yes, because its value depends on the performance of an underlying asset.
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