Stock Market Guide to Total Return Swaps
Total Return Swaps are contracts between two parties in which a reference asset or group of assets is used to provide one party with regular interest payments, plus any capital gains (or losses) over the term of the contract. The other party benefits by receiving a set or variable rate of cash flow from the first party. Thus, a Total Return Swap enables one party to receive financial compensation for owning the specified asset without formally listing said asset on their balance sheet. The other party, while retaining the asset on their balance sheet, is protected from incurring any loss to the value of the asset. An outstanding feature of total return swaps is that the reference asset never actually changes ownership.
Total Return Swaps are also known by the abbreviation “TRORS” which means Total Rate Of Return Swaps. Although similar in many respects to a Credit Default Swap (“CDS”), Total Return Swaps do not provide protection against adverse credit events. Rather, TRORS offer protection from any loss in asset value. In this respect, a total return swap is still classified as a form of “contract for difference” derivative, and not credit derivatives such as credit default swaps are. In some circles, Total Return Swaps can be defined as a form of funding-cost arbitrage.
The main users of Total Return Swaps are Hedge Funds, who take advantage of TRORS instruments’ characteristics in order to obtain and express leverage on the referenced asset or assets. In effect, it is possible for the fund to receive the return of the reference asset without spending the capital needed to purchase it. In these transactions, the other party is typically a bank or investment bank that for their part has a certain funding advantage.
Hedge funds obtain leverage on the reference asset by providing a small amount of collateral at the front end of the transaction. Other users of Total Return Swaps are pension funds, university endowment funds, mutual funds and both commercial and investment banks.