Total return swap

Diagram explaining Total return swap

Total return swap, or TRS (especially in Europe), or total rate of return swap, or TRORS, is a financial contract which transfers both the credit risk and market risk of an underlying asset.

Contract definition

Let us assume that one bank (bank A) owns an asset (e.g. a bond) which periodically gives interest rate payments. Assume that bank A (the protection buyer) and bank B (the protection seller) have entered a total return swap contract. According to this contract, bank A is paying all interest payments on the reference asset, plus any capital gains (positive price changes of the asset) over the payment period to bank B. Furthermore, bank B is paying LIBOR plus a spread as well as any negative price changes of the asset. In case of a default of the underlying asset, the asset is valued to zero and bank B has to pay the full initial market price of the asset (which was valid at the start of the contract).

The reference asset may be any asset, index, or basket of assets. TRORS are particularly popular on bank loans, which do not have a liquid repo market.

Advantage of using Total rate swaps

The TRORS allows one party to derive the economic benefit of owning an asset without putting that asset on its balance sheet, and allows the other (which does retain that asset on its balance sheet) to buy protection against loss in its value. ^[1]

A similar situation is if bank A gives bank B a loan used to finance the transfer of ownership of the underlying asset from bank A to bank B. In this case bank B gets the same capital flows as in the case of a total rate swap (with indefinite contract length). Here the underlying asset is used as collateral for the loan. The use of a total rate swap in this situation is advantageous to bank A, because the bank has no potential legal problems selling the underlying asset (because this asset is in the ownership of the bank). ^[2]

TRORS can be categorised as a type of credit derivative, although it should be noted that the product combines both market risk and credit risk, and so is not a pure credit derivative.

When loans are structured as a “total return swap” — the lending parties claims won’t be stayed along with other creditors’ if the borrowing party files for Chapter 11 bankruptcy. The lender can extract payments it is owed outside of the normal bankruptcy process. ^[3]

Users

Hedge funds are using Total Return Swaps to obtain leverage on the Reference Assets: they can receive the return of the asset, typically from a bank (which has a funding cost advantage), without having to put out the cash to buy the Asset. They usually post a smaller amount of collateral upfront, thus obtaining leverage.

Hedge funds (such as The Children's Investment Fund (TCI)) have attempted to use Total Return Swaps to side-step public disclosure requirements enacted under the Williams Act. As discussed in CSX Corp. v. The Children's Investment Fund Management, TCI argued that it was not the beneficial owner of the shares referenced by its Total Return Swaps and therefore the swaps did not require TCI to publicly disclose that it had acquired a stake of more than 5% in CSX. The United States District Court rejected this argument.^[4]

Total Return Swaps are also very common in many structured finance transactions such as Collateralized Debt Obligations (CDOs). CDO Issuers often enter TRS agreements as protection seller in order to leverage the returns for the structure's debt investors. By selling protection, the CDO gains exposure to the underlying asset(s) without having to put up capital to purchase the assets outright. The CDO gains the interest receivable on the reference asset(s) over the period while the counterparty mitigates their market of risk.

External links

• Total Return Swap article on Financial-edu.com

References

1. ^ Dufey, Gunter; Rehm, Florian (2000). An Introduction to Credit Derivatives (Teaching Note). http://hdl.handle.net/2027.42/35581. Retrieved 2008-09-03. 
2. ^ Hull, John C. (2006). Options, Futures, and other derivatives, 6th Edition. , page 516
3. ^ Winkler, Rolfe (2009). "Why privilege derivatives?". http://blogs.reuters.com/rolfe-winkler/2009/10/06/why-privilege-derivatives/. Retrieved 2009-10-06. 
4. ^ 562 F.Supp.2d 511 (S.D.N.Y. 2008), see also [1]

See also

• Repurchase agreement