What is a total return swap?
A total return swap (TRS) is a financial instrument that allows two parties to exchange the total returns of an asset or a group of assets.
In a TRS, one party, known as the “payor,” agrees to pay the other party, known as the “receiver,” the total return of the underlying asset or assets. The total return includes both the income generated by the asset, such as dividends or interest, as well as any capital appreciation or depreciation. The payor also agrees to pay any fees or expenses associated with the underlying asset. In exchange, the receiver agrees to pay the payor a fixed or floating rate of interest.
A swap in which the two legs are an interest rate, whether fixed or floating, and the return on a set asset. The second party owns the asset, which is usually a set of loans, bonds, or an equity index. The advantage to a total return swap for the payer of the interest rate is that it allows him/her to benefit from the ownership of the asset without owning it. However, if the asset falls in price over the life of the swap, the payer of the interest rate is required to compensate the owner of the asset for the amount the asset has lost.
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.
What are total return swaps used for?
TRSs are often used to transfer the risk associated with an asset or portfolio of assets from one party to another. They can be used to hedge against potential losses, to speculate on the performance of an asset, or to obtain exposure to an asset without actually owning it. TRSs can be highly complex and are typically used by sophisticated investors and financial institutions.