Total return swaps

In a total return swap (TRS), the protection buyer (‘synthetic short’) pays out cash
flow received on an asset, plus any capital appreciation earned on that asset. It
receives a floating rate of interest (usually LIBOR plus a spread), plus any depreciation
on the asset. The protection seller (‘synthetic long’) has the opposite profile; it receives
cash flows on the reference asset, plus any appreciation. It pays any depreciation to
the protection buying counterparty, plus a floating interest rate. This profile establishes
a TRS as a synthetic sale of the underlying asset by the protection buyer and
a synthetic purchase by the protection seller. Figure 11.3 illustrates TRS cash flows.

TRSs enable banks to create synthetic long or short positions in assets. A long
position in a TRS is economically equivalent to the financed purchase of the asset.
However, the holder of a long position in a TRS (protection seller) does not actually
purchase the asset. Instead, the protection seller realizes all the economic benefits
of ownership of the bond, but uses the protection buyer’s balance sheet to fund that
‘purchase’.
TRSs enable banks to take short positions in corporate credit more easily than is
possible in the cash markets. It is difficult to sell short a corporate bond (i.e. sell a
bond and hope to repurchase, subsequently, the same security at a lower price),
because the seller must deliver a specific bond to the buyer. To create a synthetic
short in a corporate exposure with a TRS, an investor agrees to pay total return on
an issue and receive a floating rate, usually LIBOR (plus a spread) plus any depreciation
on the asset. Investors have found TRSs an effective means of creating short
positions in emerging market assets.
A TRS offers more complete protection to a credit hedger than does a CDS, because
a TRS provides protection for market value deterioration short of an outright default.

A credit default swap, in contrast, provides the equivalent of catastrophic insurance;
it pays out only upon the occurrence of a credit event, in which case the default
swap terminates. A TRS may or may not terminate upon default of the reference
asset. Most importantly, unlike the one-way credit exposure of a CDS, the credit
exposure in a TRS goes both ways. A protection buyer assumes credit exposure of
the protection seller when the reference asset depreciates; in this case, the protection
seller must make a payment to the protection buyer. A protection seller assumes
credit exposure of the protection buyer, who must pay any appreciation on the asset
to the protection seller. A protection buyer will suffer a loss only if the value of the
reference asset has declined and simultaneously the protection seller defaults. A
protection seller can suffer a credit loss if the protection buyer defaults and the value
of the reference asset has increased.
In practice, banks that buy protection use CDSs to hedge credit relationships,
particularly unfunded commitments, typically with the objective to reduce risk-based
capital requirements. Banks that sell protection seek to earn the premiums, while
taking credit risks they would take in the normal course of business. Banks typically
use TRSs to provide financing to investment managers and securities dealers. TRSs
thus often represent a means of extending secured credit rather than a credit hedging
activity. In such cases, the protection seller ‘rents’ the protection buyer’s balance
sheet. The seller receives the total return of the asset that the buyer holds on its
balance sheet as collateral for the loan. The spread over LIBOR paid by the seller
compensates the buyer for its funding and capital costs.
Credit derivative dealers also use TRSs to create structured, and leveraged, investment
products. As an example, the dealer acquires $100 in high-yield loans and
then passes the risk through to a special-purpose vehicle (SPV) by paying the SPV
the total return on a swap. The SPV then issues $20 in investor notes. The yield, and
thus the risk, of the $100 portfolio of loans is thus concentrated into $20 in securities,
permitting the securities to offer very high yields.7