A total return swap (TRS) is a financial contract that transfers both the credit risk and market risk of an underlying asset. In a TRS agreement, 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. The underlying asset, referred to as the reference asset, is usually an equity index, loans, or bonds. The party receiving the total return collects any income generated by the asset and benefits if the price of the asset appreciates over the life of the swap. In exchange, the total return receiver must pay the asset owner the set rate over the life of the swap.
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 provide the benefit of a large exposure to an asset with a minimal cash outlay. The two parties involved in a total return swap are known as the total return payer and the total return receiver.
Total return swaps are also very common in many structured finance transactions such as collateralized debt obligations (CDOs). Banks and other financial institutions use TRS agreements to manage risk exposure with minimal cash outlay. The major participants in the total return swap market include large institutional investors such as investment banks, mutual funds, commercial banks, pension funds, funds of funds, private equity funds, insurance companies, NGOs, and governments.
One of the benefits of total return swaps is their operational efficiency. In a TRS agreement, the total return receiver does not have to deal with interest collection, settlements, payment calculations, and reports that are required in a transfer of ownership transaction. The other major benefit of a total return swap is that it enables the TRS receiver to make a leveraged investment, thus making maximum use of its investment capital.
