A total return swap is a dynamic financial agreement where one party makes payments based on a set rate, either fixed or variable, while another party makes payments based on the return of an underlying asset. This return includes both the income it generates and any capital gains. The underlying asset, or reference asset, in total return swaps typically consists of an equity index, a basket of loans, or bonds. The asset is distinguished by being owned by the party receiving the set rate payment.
Key Takeaways
- Dual Party Payments: In a total return swap, one party makes payments according to a set rate, while another makes payments based on the yield of an underlying asset.
- Reference Asset Benefits: The receiving party gains the benefits of the reference asset without direct ownership.
- Income Generation and Rate Payment: The receiver also collects any generated income but must pay a set rate over the duration of the swap.
- Risk Sharing: The receiver takes on systematic and credit risks, whereas the payer avoids performance risk but assumes the credit exposure risk.
Understanding Total Return Swaps
A total return swap allows the party receiving the total return to gain exposure and benefit from a reference asset without actually owning it. These swaps are popular with hedge funds because they provide significant exposure to an asset with minimal cash outlay. The two parties involved in a total return swap are the total return payer and the total return receiver.
A total return swap shares similarities with a bullet swap; however, with a bullet swap, payment is deferred until the swap ends or the position is closed.
Requirements for Total Return Swaps
In a total return swap, the party receiving the total return collects any income generated by the asset and benefits from any appreciation in the asset’s price over the swap’s life. In return, the total return receiver must pay the asset owner a set rate over the swap’s duration.
If the price of the asset falls during the swap, the total return receiver faces paying the asset owner the amount by which the asset has depreciated. The receiver thus assumes market and credit risk, while the payer avoids the risk associated with the asset’s performance but takes on the credit risk to which the receiver may be subject.
Total Return Swap Example
Assume two parties enter a one-year total return swap arrangement where one party receives the London Interbank Offered Rate (LIBOR) plus a fixed margin of 2%. The other party receives the total return of the Standard & Poor’s 500 Index (S&P 500) based on a principal amount of $1 million.
After one year, if LIBOR is 3.5% and the S&P 500 appreciates by 15%, the first party pays the second party 15% and receives 5.5%. The payment is netted at the end of the swap, with the second party receiving a payment of $95,000, or \[1 million x (15% - 5.5%)\].
In an alternative scenario, consider the S&P 500 drops by 15%. Now, the first party receives 15% plus the LIBOR rate with the fixed margin, resulting in a netted payment to the first party of $205,000, or \[1 million x (15% + 5.5%)\].
Related Terms: Interest Rate Swap, Credit Default Swap, Bullet Swap, Hedge Funds, Derivatives.
References
- Commodity Futures Trading Commission. “CFTC Swaps Report Data Dictionary”. Page 9.
- Bloomberg Professional Services. “Total Return Swaps 101”.
