What Is a Total Return Swap? Types of Total Return Swaps, Examples, and Pros and Cons

What is a “Total Return Swap”?

A TRS, or Total Return Swap, is a derivative financial product. One side pays the money using a fluctuating interest rate, while the other gets a fixed payment for the return of the asset. You may use a bond, an equity index, a basket of securities, or anything else as the reference asset. We may state that the performance of the underlying asset or instrument determines the parties’ obligation to make payments to one another. It is also known as the complete return swap.

There are several advantages to such an arrangement, such as having access to any asset or instrument but not having to own it yourself. There will still be a price and default risk for the holder, though. In addition, the other party is covered in the event that the asset’s value decreases. In addition, the other party is shielded from a decrease in the asset’s value. This gives traders more options and lowers the amount of money they need to start a transaction.

Such swaps are used by banks and other financial organisations to keep their cash outlays to a minimum. In recent years, such swaps have grown more common as a result of stricter rules after the financial crisis of 2008.

Total Return Swaps come in many forms

Two forms of total return swaps exist:

Derivatives of Credit

Debt, such as a bond, loan, or MBS (Mortgage-Backed Securities), is the underlying asset in this form of TRS. Using a TRS like this enables a company to reduce its credit risk.

Derivatives on Equity

A basket of stocks or an index is used as the underlying asset in this strategy. This sort of derivative’s total return is influenced by a variety of factors, including changes in the asset’s price, dividends, fees, and so on.

Who Invests in Total Return Swaps?

First, these swaps were mostly used by commercial banks. There are several instances in which the assets of one bank are transferred to another bank that has capacity in its balance sheet for more assets.

The TRS has become a popular investment vehicle for major institutional investors. Commercial banks, insurance firms, investment banks, governments, pension funds, and others are examples of institutional investors. As an example, SPVs (Special Purpose Vehicles), such as REITs, are allowed to engage in the TRS market.

The TRS market is now dominated by hedge funds and SPVs. They leverage balance sheet arbitrage with these swaps. As an example, a hedge fund may lease an asset from large institutional investors, such as investment banks, in order to get exposure to that asset. The hedge fund would be able to increase the return on its investment without really owning the asset.

LIBOR-based payments, on the other hand, would allow institutional investors to generate more money. In addition, they are protected against a decrease in the asset’s value.

What is the Process?

There are two parties involved in a TRS: the payer and the recipient.

We’ll call them A and B for simplicity’s sake. It is Party B that pays Party A, and it is this party that receives the funds. The value of the underlying asset is always a factor in the payout. Moreover, it must be done within a particular time period. In the event that the asset’s value decreases over this time period, Party A is obligated to make a payment to Party B. We refer to this kind of investment as a synthetic one.

Without really owning or making any significant investment, a TRS allows a party to get a return on the asset’s revenue without actually owning it. In addition, the same entity will reap the benefits of any increase in the asset’s value. As a result, the recipient would get interest income (if any) and an increase in the asset’s value.

During the term of the contract, the recipient is required to pay the asset owner the base interest rate, such as LIBOR. Despite not being exposed to the asset’s hazards, the first party (the recipient) is subject to the credit risk it poses. As an example, if the asset’s value decreases over the contract time, the receiver must pay back the asset’s owner an identical amount.

As a result, the receiver is obligated to safeguard the asset owner (or payer) against a decrease in the asset’s value. All positive returns from the asset will be given to recipients in exchange for the payment of a fee. Payments will be made on a fluctuating interest rate basis by the recipient.

Total Return Swap Example

Assume that A and B sign a one-year TRS contract in which A is the recipient and B is the payee. There is a $10 million main investment in the Standard & Poor’s 500 Index. Libor plus a two-percent margin will determine B’s payment.

Let’s say the LIBOR rate is 2.5% and the S&P 500 gains 10% at the end of the year. As a result, A will get 10% and pay 4.5%. (2.5 percent plus 2 percent ). A’s net profit will be: $0.55 million [$10 million x 10% – 4.5 percent]

Let’s say the S&P 500 falls by 10% in a year, but the LIBOR rate stays at 2%. When the value of the underlying asset decreases by a certain amount, A will have to reimburse B for that decrease in value. Consequently, B will get a total of 10% + 4.5%. $1.45 million [$10 million x 10% + 4.5 percent] is B’s total return.

A Review of TRS’ Pros and Cons

Operational efficiency is the primary advantage of TRS. The following are some of the advantages:

  • In the event of a transfer of ownership, the recipient does not need to be concerned about any paperwork that is required.
  • The asset’s owner does not have to give up ownership of the asset in order to transfer the asset.
  • The payment and maturity dates may be set by both parties.
  • In order for the TRS contract to mature, it does not have to coincide with the expiration date of the assets it represents. As a result, the TRS may expire before the underlying asset’s scheduled expiration date. TRS, on the other hand, may be valid just for the duration of the underlying asset’s expiration time.
  • By using leveraged investments, the recipient may maximise their investment.
  • The receiver does not have to fork out a large sum of money in order to acquire the property.
  • Investors may be able to get entry to previously inaccessible markets.

A TRS contract has the following drawbacks:

  • Counterparty risk is a concern for parties to a TRS contract. Even if the receiver has sufficient funds, it may fail to meet its obligations if asset values continue to decline. Due to hedge funds’ high secrecy and classification of such assets as off-balance sheet things, such a risk is compounded.
  • Interest rate risk affects parties as well. LIBOR determines how much the recipient will pay. As a consequence, the payer will see a difference in their payment if the movement is either up or down.

The Last Word

The Total Return Swap (TRS) is a well-liked derivative. It’s a way for an investor to profit from an asset even if they don’t own it. It also protects the owner of the asset against a decline in the asset’s value. Because of this, the owner of the asset will get a consistent flow of revenue from it based on the variable interest rate.

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