A Total Return Swap is a swap agreement in which one party makes payments based on a set rate, either fixed or variable, while the other party makes payments based on the return of an underlying asset, which includes both the income it generates and any capital gains. In total return swaps, the underlying asset, referred to as the reference asset, is usually an equity index, loans, or bonds. This is owned by the party receiving the set rate payment.
Total return swap or TRS, is a financial contract which transfers both the credit risk and market risk of an underlying asset.
Total return swaps allow the party receiving the total return to gain exposure and benefit from a reference asset without actually having to own it. These swaps are popular with hedge funds because they get the benefit of a large exposure with a minimal cash outlay.
In a total return swap, the party receiving the total return will receive any income generated by the asset as well as benefit if the price of the asset appreciates over the life of the swap. In return, the total return receiver must pay the owner of the asset the set rate over the life of the swap. If the price of the assets falls over the swap’s life, the total return receiver will be required to pay the asset owner the amount by which the asset has fallen in price.
Advantages:
1) The TRS allows one party to derive the economic benefit of owning an asset without putting that asset on its balance sheet, and allows the other to buy protection against loss in its value.
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.
3) 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 bankruptcy.