Total return swap refers to a swap agreement where one party makes payments on the basis of the set rate while the other party makes payments on the basis of the underlying asset return. The payments made by the first party in the total return swap may be either fixed or variable. The underlying assets are termed as the reference assets in the total return swap and they are generally equity index, loans or bonds. These assets are actually owned by the party that receives the set rate payment.
The party that receives the total return in the total return swap is benefited from the reference assets without even owning them. The total return swaps are hugely popular with the hedge funds as they receive the benefit of huge exposure with a minimal outlay of cash.
The party receiving the total return in the total return swap will get any income that is generated by the asset and also the benefit if the price of the reference assets appreciates over the swap�s life.
In return to this the total return receiver in the process pays the asset owner the set rate over the swap�s life. In the cases when the price of the assets falls over the life of the swap, the total return receiver will have to pay the owner of the asset the exact amount by which the asset has fallen in price.
Total rate of return swap (TRORS) can also referred to as the credit derivative category. But while going for total return swap, it should be noted that the product is not a pure credit derivative and combines both credit risk and market risk.
The total return swap gives one party the economic benefit of owning an asset while not putting that asset on the balance sheet. It also allows the other party to buy the protection against loss in value of its asset.
The major difference between credit default swap and a total return swap is that the former actually acts as a buffer not against the asset value loss but against specific credit events. The use of total return swap is mainly enjoyed by the hedge funds. They use total return swaps in order to obtain leverage on the reference assets.
Last Updated on : 1st July 2013