What Is Total Return Swap (TRS)?

A Total Return Swap (TRS) is a swap agreement in which one party agrees to make payments based on the total return of an underlying asset, while the other party agrees to pay a fixed rate of interest

Total return swaps are often used as a way to gain exposure to a particular asset class without having to purchase the underlying security. Total return swaps can be used to gain exposure to an index, commodity, stock, or other assets. 

Usage of Total Return Swap

Total return swaps are commonly used by investors who want to gain exposure to a particular asset class without having to purchase the underlying security. Total return swaps can also be used to reduce the cost of holding an asset. 

Originally, it was created as a way for banks to hedge against non-payment of a loan or group of loans by an entity. 

Total return swaps have since been used to speculate on the total return generated by a company’s stock, offer tax advantages to institutions that invest in certain securities.

Likewise, it has been used as credit risk substitutes/insurance for companies seeking to hedge against the risk of default on a loan or group of loans. 

They are also used as an effective hedging tool. Total Return Swaps are typically over-the-counter instruments but can be found in some futures contracts as well.

Box Index Total Return Swap 

An interesting Total Return Swap example is the Box Index Total Return Swap. The Box Index Total Return Swap pays the total return of the S&P 500 Price Index, minus a management fee, over the life of the swap. 

The party receiving the payments agrees to pay a fixed rate of interest on a notional amount each year. 

The party paying the total return agrees to pay an interest rate that varies according to prevailing market rates. 

Elements for Total Return Swap

However, there are a few required elements for Total Return Swap agreements: 

  • The underlying asset or index that the Total Return Swap is based on. 
  • The frequency and timing of payment.
  • The interest rate paid by the party receiving total return payments. 
  • The interest rate paid by the party making total return payments.

Requirements for Total Return Swap

In order to enter into a Total Return Swap, both parties must meet the following requirements:

  • The parties must have a valid Total Return Swap Agreement in place.
  • The Total Return Swap must be documented properly to avoid any disagreements between the two parties.
  • There needs to be a counterparty credit or default event that gets triggered before payments are exchanged between the Total Return Swap parties.

Importance of Total Return Swap 

Total return swaps are important because they allow traders to get exposure to different investments. Total return swaps also allow traders to gain exposure without actually having to purchase the underlying asset.

Stability and Income 

Total return swaps are also beneficial because they allow traders to get stable income. Total return swaps provide a steady stream of income, which makes them ideal for receiving monthly payments. 

Risk Mitigation and Positions 

Total return swaps are beneficial because they allow traders to hedge positions. Total return swaps give the ability to transfer risk from one entity to another, which can prevent a trader from being exposed to certain types of risk. 

Total Return Swaps also allow entities with different time horizons and tax profiles to share in each other’s risks and opportunities through a swap.

Advantages of Total Return Swap 

There are a few advantages of using Total Return Swaps: 

  1. Total return swaps provide investors with exposure to a particular asset class without having to purchase the underlying security.
  2. Total return swaps reduce the cost of holding an asset. Total return swaps are often more cost-efficient than owning the underlying security directly.
  3. Total return swaps allow you to speculate on the total return generated by a company’s stock.
  4. Total return swaps can be tax advantageous for institutions that invest in certain securities.
  5. Total Return Swaps act as credit risk substitutes/insurance for companies seeking to hedge against the risk of default on a loan or group of loans.
  6. Total return swaps are an effective hedging tool.
  7. Total return swaps can be found in some futures contracts.
  8. Total return swaps are important because they allow traders to get exposure to different investments.
  9. Total return swaps also allow traders to gain exposure without actually having to purchase the underlying asset.
  10. Total return swaps provide stability and income.
  11. Total return swaps are also beneficial because they allow traders to get stable income.
  12. Total return swaps provide a steady stream of income, which makes them ideal for receiving monthly payments.
  13. Total return swaps reduce the cost of holding an asset.
  14. Total return swaps allow you to speculate on the total return generated by a company’s stock.
  15. Total return swaps can be tax advantageous for institutions that invest in certain securities.
  16. Total Return Swaps act as credit risk substitutes/insurance for companies seeking to hedge against the risk of default on a loan or group of loans.
  17. Total return swaps are an effective hedging tool.
  18. Total return swaps can be found in some futures contracts.

Disadvantages of Total Return Swap 

There are a few disadvantages of using Total Return Swaps: 

  1. Total return swaps can be complex and difficult to understand.
  2. Total return swaps can be risky if not used correctly. 
  3. Total return swaps may not be suitable for all investors.
  4. Total return swaps may not be appropriate for hedging certain risks.
  5. Total return swaps may be difficult to terminate.
  6. Total return swaps may not be suitable for all investors.
  7. Total return swaps can be expensive to set up and maintain, which reduces their liquidity

Example of Total Return Swap

Let’s say Company A wants to hedge against the risk of default on a loan it has with Company B. Company A can enter into a total return swap with Company C. 

In this scenario, Company A would pay Company C a fixed amount each month in exchange for exposure to the total return generated by Company B’s stock.

If the value of Company B’s stock increases, Company A would earn a profit. If the value of Company B’s stock decreases, Company A would lose money. 

The Bottom Line

Total return swaps can be used in a number of different ways, which is why they are beneficial to investors. Total return swaps offer a way to get exposure to an asset class, reduce the cost of holding an asset, and provide stable income. 

Total return swaps also allow traders to mitigate risk and share in different risks and opportunities. Overall, total return swaps are a valuable investment tool. 

A Total Return Swap (TRS) is a contract between two parties in which one party agrees to pay the other party a fixed sum each month in exchange for exposure to the total return generated by a particular security or securities.
TRS allows investors to gain exposure to different asset classes without having to purchase those assets. It also provides an alternative way for individual and institutional investors to reduce the cost of holding assets as well as manage risk.
In order to enter into a TRS, both parties must be creditworthy and the contract must be based on an underlying index or securities.
Some advantages of using a TRS include the ability to get exposure to an asset class without purchasing the asset, the ability to reduce the cost of holding assets, providing a stable monthly income, and mitigating risk.
Some disadvantages of using a Total Return Swap include complex and difficult to understand, risky if not used correctly, not suitable for all investors, may not be appropriate for all investors, and difficult to terminate.

Disclaimer: The above references an opinion and is for information purposes only. It is not intended to be investment advice. Seek a duly licensed professional for investment advice.

True Tamplin, BSc, CEPF®

About the Author
True Tamplin, BSc, CEPF®

True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.

True is a Certified Educator in Personal Finance (CEPF®), a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.

To learn more about True, visit his personal website, view his author profile on Amazon, or check out his speaker profile on the CFA Institute website.