A total return swap is a contract using which two entities agree to exchange the returns on an asset. The contract sets a rate that the receiving entity needs to pay to the asset owner in exchange for the returns from the asset. Financial institutions and banks minimize their cash spending and manage their risk using these total return swap agreements.
Read on to understand how the Total Return Swap works, examples, its structure of transaction, benefits and limitations.
The total return swap contract is between two parties viz. the receiver and the payer. The working of these swaps can be defined as a promise between a payer and receiver where the payer holds an asset but buys protection against any prospective decrease in its value by promising to pay all the profits from price increases to the receiver. The receiver pays a floating interest rate across the contract duration to facilitate this exchange.
Here is an easier explanation of the functioning of total return swaps.
Suppose the parties are X and Y. Party X receives the total returns from Party Y, which is the owner of the asset. The payments are made according to the changes in the price of the asset. There is a pre-decided time frame over which the value changes of the asset are observed and these payments are made. The return that party X earns is the sum of interest accrued and the increase in asset value. However, party X will need to pay the lost amount to party Y if the price decreases during this time. These investments are commonly known as synthetic investments.
This exchange is based on a base interest rate that party X must pay during the agreement period.
Total return swaps fall into two categories:
When the underlying asset is a debt product, the swap is termed a credit derivative. Some asset types in this category include loans, bonds, mortgage-backed securities, etc. The objective of these total return swaps is to minimize credit risk. and equity derivatives.
Equity derivatives are those that have equity as the underlying asset. These are also called equity total return swaps. The total return from this derivative type is affected by asset price changes, commissions, and dividends.
A total return swap contract comprises a payer and a receiver. Banks, insurance companies, portfolio managers with high liquidity and fixed income, and hedge funds are the payers that may get into a TRS contract. The asset that forms the basis of these transactions can be a bank loan, a sovereign bond, or a corporate bond. The amount that the receiver gets as a part of this transaction includes the interest on the asset and any increase in the asset value. In return, they must make a LIBOR-based payment (London Interbank offered rate) to the payer who essentially owns the asset. They must also pay them in case there is any drop in the value.
Suppose two parties X and Y sign a one-year total return swap agreement with X as the receiver and Y as the asset owner. Taking the underlying asset as S&P 500 and the principal as $20 million. The amount that Y gets will be based on the LIBOR rate. They will also get a margin of 2%.
Assuming the LIBOR rate to be 2.5% and the annual increase in S&P 500 as 10%. X will now have to pay 2.5% +2% as the total rate of return swap and will get 10%. Thus, the net income for X is 1.1 million [20 million * (10%-4.5%)]
Now assuming that the index decreases by 10% and the LIBOR rate remains the same. Now, X will not get anything and pay Y for the loss incurred on the underlying asset. Thus, Y will receive 10% + 4.5% and the total return for Y will be $2.9 million.
Let us understand how total return swap valuation is done:
Suppose A wishes to invest in a company but cannot afford a large investment. They can approach someone (say B) who already has a significant number of shares in the company. If B wishes to get a stable cash flow, they can get into a total return swap agreement with A. The agreement will allow A to access the total return of the stock upon monthly payment for a fixed duration. This is termed a financing charge. B will promise to pay the total return of a pre-decided number of shares of the company’s stock for the decided duration.
Assuming the monthly payment from A to be $50 per month and the duration as 5 years. Also, taking the number of shares as 1000.
The stock price at the time of signing the contract is $6 per share. The company issues a dividend of $1 per share the following year. Upon receiving the dividend, B pays $1000 to A as the dividend amount for the total shares in the total return swap.
After 5 years, the share price of the company increases to $8 per share. B will now pay $3000 to A (price increase * the total number of shares involved in the total return swap). A, the receiver has paid a total of $3000 as a part of the contract and received $4000 as income and capital gains.
On the contrary, if the share price falls to $4 per share at the end of 5 years, A will have to pay $1000 to B (price decrease per share * total number of shares in total return swap). This way A will pay $4000 in all and receive $1000 as income.
This is how total return swaps yield results. However, in reality, index values form the basis of total return swaps. Also, the payments are generally based on a common financial benchmark and the payer also pays based on an index.
Total return swaps are very efficient to execute. The contract doesn’t require the receiver to worry about settlements, collecting interest, calculating payments and other requirements of ownership transactions.
The owner of the asset continues to be the owner and there is no complex asset transfer process involved. Both the receiving and paying entities together decide the payment and maturity dates. Also, the maturity date of the contract doesn’t have to sync with the asset expiry date.
Another TRS advantage is that the receiver doesn’t have to shell out a big sum at once and can use their investment capital effectively without any ownership transfer. Thus, the receiver will not have to invest huge capital in asset purchase. This makes a TRS a popular option for hedge fund and special-purpose vehicle financing.
Following are the disadvantages associated with total return swaps:
Both parties in a total return swap agreement are subjected to different risks, including the counterparty risk. When a hedge fund signs multiple TRS agreements based on similar assets, a reduction in asset value will lead to lower returns, since the fund will have to continue paying the TRS owner regularly.
If the asset value continues to decrease for a long time and the hedge fund is not capitalized sufficiently, the payer will be at risk of fund default. The risk is also more because these assets are considered and dealt with as off-balance sheet items and hedge funds are highly secretive.
Interest rate risk in a TRS contract affects both the payer and receiver. If the LIBOR increases in contract duration, the payer gets higher payments and vice versa. However, it is higher for the receiver and they may mitigate it through interest-rate derivatives like futures.
Investors who do not wish to invest a huge sum to buy an asset but still wish to get exposure to that security class, often invest in TRS. These include large institutions like mutual funds, commercial banks, investment banks, pension funds, hedge funds, pooled funds, NGOs, governments, insurance companies, and private equity funds. Other participants also include real estate investment trusts and collateralized debt obligations, which fall under the umbrella of special purpose vehicles.
A total return swap is a widely used derivative instrument that benefits both the receiver and the payer. The receiver can get advantages of an asset without owning it and the payer can mitigate the risk of value decrease due to market movements. The asset owner also earns steady income in the form of regular payments from the receiver.
Ans: Bond index total return swaps are those where the underlying asset is a series of bonds. These TRS types have some notable advantages over equity total return swaps.
Ans: Payers enter total return swaps to get a regular stream of income and to mitigate the risk associated with owning an asset.
Ans: Both the receiver and the payer mutually agree to the duration of a TRS contract.
Ans: Foreign exchange swaps and total return swaps differ primarily based on what is exchanged. It is currency denominations in the case of foreign exchange swaps and the total return of an underlying asset in case of a TRS contract.
Ans: If the payment currency and the asset currency are different, there is a currency risk in a total return swap.
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