Total Return Swaps
Total Return Swaps (TRS) are slightly different from CDS in the sense that the total return swaps transfer the total economic benefit of the reference entity from the Total Return Payer to the Total Return Receiver. The TRS transfers both the credit risk and the market risk. The payments are not dependent on any credit event.
How it works?
The total return payer usually owns the reference asset and pays the total returns from the reference asset to the total return receiver. The total return includes the interest payment, a fees, and any appreciation or depreciation in the asset value.
In return, the Total return Receiver pays a Money Market Rate(e.g., LIBOR) plus a spread to the Total Return Payer.
The following diagram shows the transaction structure:
The spread is generally bounded by funding costs.
If the market value of asset declines because of a credit event or any other reason, the total returns will become negative, and the total return receiver wold have compensated the payer.
The benefit of the TRS is that the Total Return Payer is relieved of the economic burden from the reference asset. However, it has taken up counterparty exposure to the total return receiver.
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