TABLE OF CONTENTS In a total return swap (TRS), an investor (the total return receiver) enters into a derivatives contract whereby it will receive all the cash flows associated with a given reference asset or financial index without actually ever buying or owning the asset or the index. The payments are made by the other party in the TRS contract, the total return payer. Unlike an asset swap, which essentially strips out the credit risk of fixed-rate asset, a total return swap exposes investors to all risks associated with the reference asset credit, interest rate risk, etc. [1] As such, total return swaps are more than just a credit derivative. Nonetheless, derivatives dealers have customarily considered their TRS activity as part of their overall credit derivatives business.
Total return swaps come in different variations. We shall describe the most basic form first. Like other over-the-counter derivatives, a TRS is a bilateral agreement that specifies certain rights and obligations for the parties involved. In the particular case of the TRS agreement, those rights and obligations are centered around the performance of a reference asset.
For instance, suppose an investor wants to receive the cash flows associated with a fixed-rate bond issued by XYZ Corp., but is either unwilling or unable to purchase the bond outright. The investor approaches a derivatives dealer and enters into a total return swap that references the desired XYZ bond. The dealer promises to replicate the cash flows of the bond and pay them out...
