TOTAL RETURN SWAP

DESCRIPTION

"Total Return Swap" is the generic name for any non traditional swap where one party agrees to pay the other the "total return" of a defined underlying asset, usually in return for receiving a stream of LIBOR based cashflows. The Total Return Swap may be applied to any underlying asset but is most commonly used with equity indices, single stocks, bonds and defined portfolios of loans and mortgages. The Total Return Swap is a mechanism for the user to accept the economic benefits of asset ownership without utilising the balance sheet. The other leg of the swap, usually LIBOR, is spread to reflect the non-balance sheet nature of the product. Total Return Swaps can be designed with any underlying asset agreed between two parties. It is important to note that no notional amounts are exchanged with Total Return Swaps. (See Loan Swap)

EXAMPLE

Equity Index Swap

An investor looking to match the performance of say the S&P500 index has many alternatives. Simplistically, they can purchase the underlying 500 shares in the corresponding index weightings, or they could purchase S&P500 futures. Both require on-going active management, either re-balancing the portfolios, re-investing dividends or rolling futures as they mature. Alternatively, they could enter into a Total Return Swap based upon the S&P500 index for say 3 years. Each six months, the investor would receive the total return of the index and pay say US LIBOR plus 30bp. The investor has achieved a return exactly indexed to the S&P500 at a cost of only 30bp per annum (the premium they have to pay above LIBOR). While the investor needs to pay the premium of 30bp, they do not have any of the on-going management concerns and the swap is not classified as an asset so they are not required to fund the S&P500 position.

Loan Swap

Investors have traditionally invested in Bonds, Equities and Property. In an effort to diversify risk, investors look to new asset classes. The Loan market has traditionally been almost exclusively dominated by banks. Using the Total Return Swap, an investor can achieve exposure to this new asset class, previously un-obtainable. Assume Bank A has a 3 yr fixed rate 8% loan to Company Z. The loan therefore sits as an asset on Bank A?s balance sheet. An investor seeking exposure to Company Z may enter into a Total Return Swap with Bank A so that the total returns of the loan, including interest and any default shortfall, are passed through to the investor. The investor is therefore assuming the credit and economic risk of Company Z?s loan. In return, they pay Bank A say LIBOR plus 45bp which compensates the bank for use of its balance sheet as the bank is still required to fund the loan. Should company Z default, the investor will be required to compensate the bank for any shortfall. For more detail, see Loan Swaps.

PRICING

A Total Return Swap can be thought of as buying the underlying asset or liability, and using another parties balance sheet to fund it. The returns of owning the underlying asset, and entering the Total Return Swap are the same, the only cost being the balance sheet "rental" cast paid to the balance sheet provider. This will depend upon the nature of the asset, the credit rating of the swap counterparty and bank, tenor etc.

TARGET MARKET

Total Return Swaps are applicable for any investor seeking off-balance sheet alternatives. They are particularly attractive where the user does not wish to be actively involved in portfolio or rate risk management on a day-to-day basis.

ADVANTAGES

DISADVANTAGES

PRODUCT SUITABILITY

Simple Aggressive

Total (Rate of) Return Swaps

Extracted from "Credit derivatives: A primer" issued by J.P. Morgan (February 1998)

A Total Rate of Return Swap ("Total Return Swap" or "TR Swap") is a bilateral financial contract designed to transfer credit risk between parties, but a TR Swap is importantly distinct from a Credit Swap in that it exchanges the total economic performance of a specified asset for another cash flow. That is, payments between the parties to a TR Swap are based upon changes in the market valuation of a specific credit instrument, irrespective of whether a Credit Event has occurred.

Specifically, as illustrated in the below chart, one counterparty ("the TR Payer") pays to the other (the "TR Receiver") the total return of a specified asset, the Reference Obligation. "Total return" comprises the sum of interest, fees, and any change-in-value payments with respect to the Reference Obligation. The change-in-value payment is equal to any appreciation (positive) or depreciation (negative) in the market value of the Reference Obligation, as usually determined on the basis of a poll of reference dealers. A net depreciation in value (negative total return) results in a payment to the TR Payer. Change-in-value payments may be made at maturity or on a periodic interim basis. As an alternative to cash settlement of the change-in-value payment, TR Swaps can allow for physical delivery of the Reference Obligation at maturity by the TR Payer in return for a payment of the Reference Obligation's initial value by the TR Receiver. Maturity of the TR Swap is not required to match that of the Reference Obligation, and in practice rarely does. In return, the TR Receiver typically makes a regular floating payment of LIBOR plus a spread (Y b.p. p.a. in the below chart).

The key distinction between a Credit Swap and a TR Swap is that the former results in a contingent or floating payment only following a Credit Event, while the latter results in payments reflecting changes in the market valuation of a specified asset in the normal course of business.

 

Synthetic financing using Total Return Swaps

When entering into a TR Swap on an asset residing in its portfolio, the TR Payer has effectively removed all economic exposure to the underlying asset. This risk transfer is effected with confidentiality and without the need for a cash sale. Typically, the TR Payer retains the servicing and voting rights to the underlying asset, although occasionally certain rights may be passed through to the TR Receiver under the terms of the swap. The TR Receiver has exposure to the underlying asset without the initial outlay required to purchase it. The economics of a TR Swap resemble a synthetic secured financing of a purchase of the Reference Obligation provided by the TR Payer to the TR Receiver. This analogy does, however, ignore the important issues of counterparty credit risk and the value of aspects of control over the Reference Obligation, such as voting rights if they remain with the TR Payer.

Consequently, a key determinant of pricing of the "financing" spread on a TR Swap (Y b.p. p.a. in the chart) is the cost to the TR Payer of financing (and servicing) the Reference Obligation on its own balance sheet, which has, in effect, been "lent" to the TR Receiver for the term of the transaction. Counterparties with high funding levels can make use of other lower-cost balance sheets through TR Swaps, thereby facilitating investment in assets that diversify the portfolio of the user away from more affordable but riskier assets.

Because the maturity of a TR Swap does not have to match the maturity of the underlying asset, the TR Receiver in a swap with maturity less than that of the underlying asset may benefit from the positive carry associated with being able to roll forward short-term synthetic financing of a longer-term investment. The TR Payer may benefit from being able to purchase protection for a limited period without having to liquidate the asset permanently. At the maturity of a TR Swap whose term is less than that of the Reference Obligation, the TR Payer essentially has the option to reinvest in that asset (by continuing to own it) or to sell it at the market price. At this time, the TR Payer has no exposure to the market price since a lower price will lead to a higher payment by the TR Receiver under the TR Swap.

Other applications of TR Swaps include making new asset classes accessible to investors for whom administrative complexity or lending group restrictions imposed by borrowers have traditionally presented barriers to entry. Recently insurance companies and levered fund managers have made use of TR Swaps to access bank loan markets in this way.