Question

What is a total return swap and explain how it works. What happens if the underlying asset defaults?

Answer 1

Ans ) Total return swap : A total return swap is 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, a basket of loans, or bonds. The asset is owned by the party receiving the set rate payment.

Structure of a total return swap transaction :

A TRS contract is made up of two parties, i.e., the payer and the receiver. The payer may be a bank, hedge fund, insurance company, or other cash-rich, fixed income portfolio manager. The total return payer agrees to pay the TRS receiver the total return on an underlying asset while being paid LIBOR-based interest returns from the other party–the total return receiver. The underlying asset may be a corporate bond, bank loan, or sovereign bond.

The total return to the receiver includes interest payments on the underlying asset, plus any appreciation in the market value of the asset. The total return receiver pays the payer (asset owner) a LIBOR-based payment and the amount equal to any depreciation in the value of the asset (in the event that the value of the asset declines during the life of the TRS – no such payment occurs if the asset increases in value, as any appreciation in the asset’s value goes to the TRS receiver). The TRS payer (asset owner) buys protection against a possible decline in the value of the asset by agreeing to pay all the future positive returns of the asset to the TRS receiver, in exchange for floating streams of payment .

Requirements of total return swap :

In a total return swap, 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. If the asset's price falls over the swap's life, the total return receiver will be required to pay the asset owner the amount by which the asset has fallen. In a total return swap, the receiver assumes systematic, or market, risk and credit risk. Conversely, the payer forfeits the risk associated with the performance of the referenced security but takes on the credit exposure to which the receiver may be subject.

Assume that two parties enter into a one-year total return swap in which one party receives the London Interbank Offered Rate, or LIBOR, in addition to a fixed margin of 2%. The other party receives the total return of the Standard & Poor's 500 Index (S&P 500) 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%)].

Conversely, consider that rather than appreciating, the S&P 500 falls by 15%. The first party would receive 15% in addition to the LIBOR rate plus the fixed margin, and the payment netted to the first party would be $205,000, or [$1 million x (15% + 5.5%)].

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