Total return swap
Total return swap, or TRS (especially in Europe), or total rate of return swap, or TRORS, is a financial contract that transfers both the credit risk and market risk of an underlying asset.
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[edit] Contract definition
Let us assume that one bank (bank A) owns an asset (e.g. a bond) that periodically gives interest rate payments. Assume that bank A (the protection buyer) and bank B (the protection seller) have entered a total return swap contract. According to this contract, bank A is paying all interest payments on the reference asset, plus any capital gains (positive price changes of the asset) over the payment period to bank B. Furthermore, bank B is paying LIBOR plus a spread as well as any negative price changes of the asset. In case of a default of the underlying asset, the asset is valued to zero and bank B has to pay the full initial market price of the asset (which was valid at the start of the contract).
The reference asset may be any asset, index, or basket of assets. TRORS are particularly popular on bank loans, which do not have a liquid repo market.
[edit] Advantage of using Total Rate Swaps
The TRORS allows one party (bank B) to derive the economic benefit of owning an asset without putting that asset on its balance sheet, and allows the other (bank A, which does retain that asset on its balance sheet) to buy protection against loss in its value.[1]
TRORS can be categorised as a type of credit derivative, although the product combines both market risk and credit risk, and so is not a pure credit derivative.
[edit] Users
Hedge funds are using Total Return Swaps to obtain leverage on the Reference Assets: they can receive the return of the asset, typically from a bank (which has a funding cost advantage), without having to put out the cash to buy the Asset. They usually post a smaller amount of collateral upfront, thus obtaining leverage.
Hedge funds (such as The Children's Investment Fund (TCI)) have attempted to use Total Return Swaps to side-step public disclosure requirements enacted under the Williams Act. As discussed in CSX Corp. v. The Children's Investment Fund Management, TCI argued that it was not the beneficial owner of the shares referenced by its Total Return Swaps and therefore the swaps did not require TCI to publicly disclose that it had acquired a stake of more than 5% in CSX. The United States District Court rejected this argument and enjoined TCI from further violations of Section 13(d) Securities Exchange Act and the SEC-Rule promulgated thereunder.[2]
Total Return Swaps are also very common in many structured finance transactions such as Collateralized Debt Obligations (CDOs). CDO Issuers often enter TRS agreements as protection seller in order to leverage the returns for the structure's debt investors. By selling protection, the CDO gains exposure to the underlying asset(s) without having to put up capital to purchase the assets outright. The CDO gains the interest receivable on the reference asset(s) over the period while the counterparty mitigates their market of risk.
[edit] References
- ^ Dufey, Gunter; Rehm, Florian (2000). An Introduction to Credit Derivatives (Teaching Note). hdl:2027.42/35581.
- ^ 562 F.Supp.2d 511 (S.D.N.Y. 2008), see also
[edit] External links
[edit] See also
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