Total Return Swap

What Is a Total Return Swap?

A total return swap is a swap agreement wherein one party makes payments in view of a set rate, either fixed or variable, while the other party makes payments in light of the return of an underlying asset, which incorporates both the income it generates and any capital gains. In total return swaps, the underlying asset, alluded to as the reference asset, is generally an equity index, a basket of loans, or bonds. The asset is owned by the party getting the set rate payment.

Understanding Total Return Swaps

A total return swap permits the party getting the total return to gain exposure and benefit from a reference asset without really possessing it. These swaps are well known with hedge funds since they give the benefit of a large exposure to an asset with a negligible cash outlay. The two gatherings engaged with a total return swap are known as the total return payer and the total return receiver.

A total return swap is like a bullet swap; in any case, with a bullet swap, payment is postponed until the swap closes or the position closes.

Requirements for Total Return Swaps

In a total return swap, the party getting the total return gathers any income generated by the asset and benefits on the off chance that the price of the asset increases in value 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.

Assuming 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 expects to be systematic, or market, risk and credit risk. On the other hand, the payer relinquishes the risk associated with the performance of the referenced security however assumes on the acknowledgment exposure to which the receiver might be subject.

Total Return Swap Example

Expect that two gatherings go into a one-year total return swap in which one party receives the London Interbank Offered Rate (LIBOR) notwithstanding a fixed margin of 2%. The other party receives the total return of the Standard and Poor's 500 Index (S&P 500) on a principal amount of $1 million.

Following one year, assuming LIBOR is 3.5% and the S&P 500 values by 15%, the principal party pays the second party 15% and receives 5.5%. The payment is gotten toward the finish of the swap with the subsequent party getting a payment of $95,000, or [$1 million x (15% - 5.5%)].

Alternately, consider that as opposed to appreciating, the S&P 500 falls by 15%. The primary party would receive 15% notwithstanding the LIBOR rate plus the fixed margin, and the payment got to the main party would be $205,000, or [$1 million x (15% + 5.5%)].

Features

• Total return swaps permit the party getting the total return to benefit from the reference asset without claiming it.
• The receiver expects to be systematic and credit risks, while the payer accepts no performance risk except for assumes on the acknowledgment exposure the receiver might be subject to.
• The getting party likewise gathers any income generated by the asset be that as it may, in exchange, must pay a set rate over the life of the swap.
• In a total return swap, one party makes payments as per a set rate, while one more party makes payments in view of the rate of an underlying or reference asset.