Total return swap definition
Total return swap explained
A total return swap is an agreement in which one of the parties makes a payment on a predefined rate, while the other party makes payments based on the performance, i.e. a return generated from the reference asset. The underlying asset, which is part of the agreement, can be a bond, a loan, index, commodity, or equity. The sides entering a total return swap agreement are the total return payer and the total return receiver. Total return swaps are usually used by hedge funds, banks, insurance companies and other types of funds.
With a total return swap (TRS), the receiver is taking the income earned from the asset without owning the assets. The income can be generated from a price increase or from dividends or other payments associated with the asset.
With this derivative instrument, the payers, which are asset owners, are protected from a possible decrease in asset value in the future. But they are obliged to pay any increase in the price to the receiver. On the other hand, the receiver can make profits from price movements of the underlying assets without actually owning them. It means that they don't have to invest large sums of money in order to buy the asset and make a profit from it. They can earn a return by investing lower levels of capital, i.e. by paying the LIBOR rate (base rate), or another predefined rate.
For example: two parties make a total return swap agreement. According to the contract, party A will receive the LIBOR rate plus a spread of 1 per cent. Party B will receive the return generated from Index with the principal amount of €500,000 This would mean that party B has an exposure to the asset of €500,000 without actually owning the asset. Let's say that the Index value has increased by 9 per cent while the LIBOR rate is 3 per cent. In this situation, party A will pay 9 per cent of €500,000.00 to party B, and party B will pay 4 per cent to party A. So, the overall return earned by party B will be 9 per cent - 4 per cent or 5 per cent which equals to €25,000.00 (5 per cent x €500,000.00).
Total return swap risks
There are major risks associated with this derivative instrument. The risk for the receiver is the possibility that the value of the underlying asset will decrease substantially. Having to pay any depreciation in asset value, the investors could end up with a loss. On the other side, the payer is faced with counterparty risk if the receiver is not able to meet its obligations when the price of asset value decreases.