7 - Total return swaps

Abstract

In a total return swap (TRS), an investor (the total return receiver) enters into a derivatives contract whereby the investor receives all the cash flows associated with a given reference asset or financial index without ever buying or owning the asset or the index. The payments are made by the other party in the TRS contract, the total return payer. Unlike an asset swap, which essentially strips out the credit risk of fixed-rate asset, a total return swap exposes investors to all risks associated with the reference asset—credit, interest rate risk, and so on. TRSs are more than just a credit derivative and come in different variations. Like other over-the-counter derivatives, a TRS is a bilateral agreement that specifies certain rights and obligations for the parties involved. In the case of the TRS agreement, those rights and obligations are centered around the performance of a reference asset. Investors with relatively high funding costs can use TRS contracts to synthetically own the asset while potentially reducing their funding disadvantage. The TRS market allows highly rated entities to benefit from their funding advantage.