What is total return swap

what is total return swap

Total Return Swap (TRS) PART 2

Author: Financial-edu.com

The Funding Leg counterparty is called the Total Return Receiver, Swap Buyer, Seller of protection, or Guarantor. Here, we will use the term Total Return Receiver or TRR. The TRR seeks exposure to the returns of the reference asset or basket of assets, but does not want to purchase and hold them on its balance sheet. This party "sells protection" on the TRP's asset(s) by taking a synthetic long position in the asset(s) and making regular floating cash flow payments and capital loss guarantee payments to the TRP. The TRR seeks leveraged returns, and will pay for access to those returns, while taking on the risk of capital losses.

Total Return Payers are usually large institutions with big balance sheets such as commercial banks, investment banks, mutual funds, securities dealers, and insurance companies. Total Return Payers have lower cost of funding than Total Return Buyers, but their returns are often limited by regulatory capital requirements or conservative strategies. By "leasing" a portion of its strong balance sheet with a TRS, a TRP can achieve higher returns while ensuring against capital losses.

Total Return Receivers are usually aggressive hedge funds, specialty asset managers, and CLO special vehicles who accumulate leveraged credit and sell off tranches to investors. TRRs seek maximum returns but they lack the large balance sheets of TRPs. A TRS allows a TRR to synthetically generate higher returns using leverage, while avoiding the transaction and administrative costs associated with buying the assets or entering into repo transactions.

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 LIBOR +/- spread

- 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 LIBOR +/- spread

- Pays for any capital losses

- Takes on asset return risk

- Takes on interest rate risk

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.

Source: www.financial-edu.com

Category: Forex

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