HOW DOES TOTAL RETURN SWAPS (TRS) WORKS
WHAT IS A TOTAL RETURN SWAP?
A Total Return Swap (TRS) is bilateral financial transactions where the counterparties swap the total
return of a reference asset(s) in exchange for periodic cash flows, typically a floating rate payment and a
guarantee against any capital losses. A TRS is similar to a plain vanilla swap except the deal is structured
such that the total return is exchanged, rather than just the cash flows. A TRS involves a total return
payer and a total return receiver. The party that agrees to make the floating rate payments and receive
the total return is referred to as the total return receiver or the swap buyer; the party that agrees to
receive the floating rate payments and pay the total return is referred to as the total return payer or
swap seller. The floating rate payment is usually a spread to a floating rate index such as U.S. dollar
(USD), LIBOR, or Euribor; but any index can be used, including a fixed rate index, an equity index, or a
bond performance index. An asset’s total return measures how much value it generates in total. This
includes both capital gains (when an asset gains market value – capital appreciation) and income (when
an asset makes a direct payment – For e g interest, dividend, etc). The reference asset(s) could be one
of the following:
credit-risky bond;
a loan;
a reference portfolio consisting of bonds or loans;
an index representing a sector of the bond market; or
an equity index
To Total Return Payer Total return on reference asset(s) Total Return Receiver
Legal owner of reference Long both the price and
asset, which is on balance default risk of the reference
sheet asset(s), but is not the legal
owner, so risk is Off-Balance
Floating rate payment Sheet
Total
Return
Reference Asset(s)
For example-Bonds, loans,
index,
equities
The exchange of cash flows and risks are explained below:
Total Return Payer (TRP):
Owns reference asset(s)
Has lower cost financing
Pays total return of asset(s)
Receives floating rate payment
Receives payments to offset any capital losses
Takes on interest rate risk
Transfers away asset return risk
Total Return Receiver (TRR):
Does not own reference asset(s) - has a weaker balance sheet or uses balance sheet leverage
Has higher cost financing
Receives total return of asset(s)
Pays floating rate payments
Pays for any capital losses
Takes on asset return risk
Takes on interest rate risk
ANALYSIS OF TOTAL RETURN SWAPS
Total Return Swaps allows an investor to gain exposure to a class of asset without having to own the
asset, merely paying someone else a fixed rate to hold the asset. The objective of a TRS is to transfer the
total economic exposure (market and credit risk) of the reference asset without having to purchase or
sell it. A TRS allows an investor to enjoy all of the cash flow benefits of a security without actually
owning the security. The investor receives the total rate of return. At the end of the TRS (or at pre-
arranged interim periods), the investor, the receiver of the TRS, must pay any decline in price to the TRS
Payer. If there is no decline in price, the investor does not make a payment.
Suppose an investor wants to purchase a 5-year BBB-rated bond issued by XYZ Corporation but does not
want to bear the out-of-pocket cost (and possibly inconvenience) of arranging financing, actually buying
the bond, and taking delivery. Suppose also that a bank owns the same bond and would like to extend a
loan to XYZ Corporation but its loans to XYZ and investments in XYZ debt instruments have fully
exhausted its capacity to lend to XYZ. A total return swap will allow the investor to receive the total
economic return on this bond without actually buying it.
It will allow the bank to reduce its risk exposure to XYZ Corporation as if it had sold the bond without
actually selling it. If the two entities enter into a total return swap structured around this bond’s total
return stream, the investor will be synthetically “long” the 5-year bond, and the bank will be
synthetically “short” the same bond.
The total return payer makes payments equal to the interim cash flows (interest payments on a bond)
plus any capital appreciation on the reference asset. Usually the total return receiver pays a floating
interest rate, generally one of the LIBOR (London Interbank Offered Rate) rates, plus any capital
depreciation on the reference asset. The total return payer realizes the same series of returns as if it had
sold the reference asset short; while the total return receiver realizes the same stream of returns as if it
owned the reference asset. But the total return receiver avoids having to take custody of the bond.
Since it is also obligated to make a series of specified payments, the investment in the bond is leveraged.
For example, suppose the total return recipient pays 3-month LIBOR. It effectively finances its
investments in the reference bond by borrowing at 3-month LIBOR.
In contrast to credit default swaps—which only transfer credit risk—a TRS transfers not only credit risk
(i.e. the improvement or deterioration in credit profile of an issuer), but also market risk (i.e. any
increase or decrease in general market prices). In addition, TRS contrasts with CDS since payments are
exchanged among counterparties upon changes in market valuation of the underlying and not only upon
the occurrence of a credit event as is the case with CDS contracts.
STRUCTURE OF A TOTAL RETURN SWAPS TRANSACTION
TRS deals are typically structured with a notional amount, start date, end date, and periodic dates where
asset returns are swapped for cash flows. The parties establish a regular payment calendar for transfer
of net returns. For example, the parties may set a quarterly payment calendar defined by LIBOR coupon
dates. On those dates, the Total Return Payer (or a specified third party) will mark-to-market the capital
appreciation/depreciation and accumulated cash flows of the reference asset(s). The Total Return
Receiver will calculate the required coupon consisting of LIBOR +/- a spread. Value of the reference
asset(s) is determined on a periodic basis by mark-to-market using dealer quotations, independent
pricing data, market surveys, or independent valuation. The parties will then exchange the net
difference between the values of the two legs. At expiration date of the TRS, the parties will exchange
the remainder of net returns and continue on separately as if nothing had happened.
Where the reference asset is a security with a risk of default, such as a corporate bond or basket of
bonds, the TRS agreement will normally set forth various payments and valuation steps required upon
default. The TRS agreement may simply terminate and the parties exchange cash payments according to
the value of the defaulted assets. There may be an exchange of cash or physical delivery of the
defaulted bonds. The Total Return Payer may substitute another security for the defaulted one and
continue the TRS arrangement. A lump sum payment may be due. The Total Return Receiver may have
the option to purchase the defaulted loan or bond from the Total Return Payer and then deal directly
with the defaulted loan obligor. There are many potential variations, making a TRS attractive for parties
focused on specific unique asset returns.
The TRS is initially structured so the Net Present Value (NPV) to both parties is at or close to zero. As
time progresses, the TRS gains or loses value on each leg so that one of the counterparties obtains a
profit.
Payments Received by Total Return Receiver:
If reference asset is a bond, the bond coupon
The price appreciation, if any, of the reference asset since the last fixing date
If the reference asset is a bond that defaulted since the last fixing date, the recovery value of the
bond
Payments Received by the Total Return Payer:
The periodic floating payment (usually LIBOR+/-a spread)
The price depreciation, if any, of the reference asset since the last fixing date
If the reference asset is a bond that defaulted since the last fixing date, the par value of the
bond
A simple example of a TRS would be:
Two parties may enter into a one-year total return swap where Party A receives MIBOR + fixed margin
(2%) and Party B receives the total return of the NIFTY 50 on a principal amount of INR 1 million. If
MIBOR is 6% and the NIFTY 50 appreciates by 10%, Party A will pay Party B 10% and will receive 8%. The
payment will be netted at the end .of the swap with Party B receiving a payment of INR 20,000 [INR 1
million x (10% - 8%)]
TOTAL RETURN PAYER Capital Appreciation 10% TOTAL RETURN RECEIVER
PARTY A PARTY B
MIBOR (6%) + Spread (2%)
REFERENCE ASSET
NIFTY 50
A more advanced example of a TRS would be:
In a Bank Loan TRS, a large bank such as Barclays (the Total Return Payer) purchases a loan. It then
enters into a TRS with an investor (the Total Return Receiver). The bank pays all the interest and realized
capital gains to the Seller, minus a "funding charge" (akin to an access fee to the bank's balance sheet).
The investor pays LIBOR plus a spread, plus any realized capital losses to the bank. Initial collateral (the
"haircut" or "Independent Amount" in swap language) of between 15% and 80% is paid to the bank by
the investor at the inception of the TRS. The bank holds this collateral in a separate account and pays
the investor periodic interest at the Fed Funds Effective Rate. Collateral treatment is typically "full
recourse", meaning the investor must post additional collateral if the asset value drops, or may
withdraw collateral if the asset value increases. The reference assets (loans) are periodically marked to
market using LoanX, LPC, or dealer quotes. A Bank Loan TRS can be executed on a single loan (typical
trade size US$5-10MM, up to $50MM) or a portfolio of loans (typical trade size US$250-750MM, up to
$1B+).
Thus, TRS is a swap transaction where it exchanges two streams of cash flows
Total Return Payer pays total returns of a reference asset where ,
TOTAL RETURN = CAPITAL APPRECIATION + INCOME (INTERIM CASH FLOWS)
Total Return Receiver pays FLOATING RATE PAYMENTS + CAPITAL DEPRECIATION
No notional exchange at maturity of the swap
Is strictly institutional over the counter (OTC)
OBJECTIVE – Transfer the total economic exposure MARKET RISK + CREDIT RISK of the reference
asset without having to purchase or sell it.
