Total Return 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.

Total (Rate of) Return Swaps

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.