What Are Total Return Swaps?
A total return swap (TRS) is a financial derivative contract in which one party agrees to pay the total return on a security or index to another party in exchange for periodic payments.
The total return includes the appreciation/depreciation and any income the security generates, such as dividends or interest payments.
How Does a Total Return Swap Work?
Banks or other financial institutions typically use TRS contracts to manage risk with minimal cost.
When two parties enter a total return swap agreement, the return on a specified asset or basket of assets exchanges between them.
One party, called the payer, agrees to make payments to the other party, called the receiver, based on the total return generated from an underlying asset or group of assets.
This can be a great way for companies to hedge their investments and protect themselves from any downside risk.
Total Return Swap Risks
TRS contracts are not without risk, however.
If the underlying asset or index performs poorly, the payer may have to make large payments to the receiver, which can strain their finances.
Additionally, total return swaps are often complex financial instruments that can prove tricky to value and understand.
As a result, they may not prove suitable for all investors.
Total Return Swaps in Action
Company ABC and Company XYZ, two large multinational corporations, enter into a total return swap agreement.
Company ABC agrees to pay Company XYZ the total return on a basket of assets over the next five years.
Company ABC will make payments to Company XYZ if the underlying assets appreciate during that time.
If the underlying assets appreciate during that time, Company ABC will make payments to Company XYZ.
However, if the underlying assets depreciate, Company XYZ will make payments to Company ABC.
Total Return Swap Results
The asset owner avoids the risk directly associated with the asset but assumes the credit exposure risk.
They are complex financial instruments that can be difficult to value and understand and may not suit all investors.
Before entering a total return swap agreement, consider the risks involved.
Bond Index Total Return Swaps
A bond index total return swap (BITRS) is a type of total return swap in which the underlying asset is a bond index, such as the Barclays Capital U.S. Aggregate Bond Index.
Financial institutions and large investors use BITRS contracts to gain access to a bond market without the requirement of buying and selling bonds.
Why Do Payers Enter a Total Return Swap?
There are many reasons why a company or investor might enter into a total return swap agreement.
TRS contracts can help mitigate market risk, speculate on the long-term performance of a particular security or index, and generate income.
Payers may also enter into total return swap agreements to access the total return on a security or index they would not otherwise have the means to access.
The Bottom Line
Total return swaps are contracts with a set number of payments and a specified end date. They utilize stocks, bonds, and other forms of securities.
Large investors and financial institutions often use TRS contracts, but they may not suit all investors.
Consider the risks involved before entering a total return swap agreement.
Paying the total return on a security or index can generate income, but it is crucial to understand the risks before entering into a total return swap agreement.
Total return swaps are complex financial instruments that can help assess market risk while speculating on the long-term performance of a security or index.
FAQs
1. What are the types of total return swaps?
There are many types of total return swaps. The most common are equity total return swaps, bond total return swaps, and index total return swaps.
2. Is it possible to lose money on a total return swap?
Yes, it is possible to lose money on a total return swap. If the underlying asset or index performs poorly, the payer may have to make large payments to the receiver, which can strain their finances.
3. Does the total return swap involve any credit risk?
Yes, a total return swap involves credit risk. If the payer defaults on their payments, the receiver may not receive the amount they are owed. Additionally, if the underlying asset or index declines in value, the payer may have to make large payments to the receiver.
4. What do you call the total return on a security or index?
The total return on a security or index is the sum of the capital gains and dividends earned on that security or index over a period. It is often expressed as a percentage. The total return on an index is often called the "index return".
5. How does the government regulate total return swaps?
The total return swap market is regulated by the Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC). The CFTC has authority over total return swaps traded on registered exchanges, while the SEC has authority over total return swaps not traded on registered exchanges. The CFTC and the SEC require total return swaps to be traded on regulated exchanges to protect investors from fraud and manipulation. These regulations promote fairness and transparency in the total return swap market.
