Total return swaps

In some versions of a TRS, the underlying asset is sold to the counterparty, with a corresponding swap transacted on the side in other versions the underlying asset remains unsold. The term of the TRS need not match the maturity of the underlying security and, in fact, rarely does. 

Total return payer Total return receiver 

The swap payer can reduce or remove credit risk without selling the relevant asset. In a vanilla TR swap, the total return payer retains rights to the reference asset, although, in some cases, servicing and voting rights may be transferred. At swap maturity, the swap payer can reinvest the asset, if it still owns it, or sell it in the open market. The swap can thus be 

TR swaps may also be used for speculation. Bond traders who believe that a particular bond not currently on their books is about to decline in price have a couple of ways to profit from this view. One method is to sell the bond short and cover their position through a repo. The cash flow to the traders from this transaction consists of the coupon on the bond that they owe as a result of the short sale and, if the shorted bond falls in price as expected, the capital gain from the short sale plus the repo rate—say, LIBOR plus a spread. The danger in this transaction is that if the shorted bond must be covered through a repo at the special rate instead of the higher general collateral rate—the one applicable to Treasury securities— the traders will be funding it at a loss. The yield on the bond must also be lower than the repo rate. 

Alternatively, the traders can enter into a TR swap in which they pay the total return on the bond and receive LIBOR plus a spread. If the bond yield exceeds the LIBOR payment, the funding will be negative, but the trade will still gain if the bond falls in price by a sufficient amount. The traders will choose this alternative if the swaps break-even point— the price to which the bond must decline for a gain from the short sale to offset the trade s funding cost—is higher than in the repo approach. This is more likely if the bond is special. 

The swap payments are usually quarterly or semiannual. On the interest-reset dates, the underlying asset is marked to market, either using an independent source, such as Bloomberg or Reuters, or as the average of a range of market quotes. If the reference asset obligor defaults, the swap 

This section explores the ways banks and fund managers may use credit derivatives. 

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There is a wide range of uses to which repo might be put. Structured transactions that are very similar to repo include total return swaps, and other structured repo trades include floating-rate repo that contains an option to switch to a fixed rate at a later date. In the equity market repo is often conducted in a basket of stocks, which might be constituent stocks in an index such as the FTSEIOO or CAC40 or user-specified bas-... 

Credit derivative products are defined by reference to underlying reference entities, and reference obligations, which include corporate bonds, bank loans, sovereign debt, Brady bonds, and Eurobonds. Credit derivatives are now used increasingly in structured transactions. For example synthetic collateralised loan obligations (see Chapter 15) often use credit default swaps to transfer credit risk from the originator to the special purpose vehicle (SPV). Currently, the most common products are credit default products and total return swaps. 

A total return swap (TRS) is a derivative instrument that allows the protection buyer to swap the total economic return of an asset (e.g., loans or securities) for fixed or floating interest payments. 

EXHIBIT 21.6 Total Return Swap as Used in Jazz ICDO BV... 

Various credit derivatives may be priced using this model for example, credit default swaps, total return swaps, and credit spread options. The pricing of these products requires the generation of the appropriate credit dependent cash flows at each node on a lattice of possible outcomes. The fair value may be determined by discounting the probability-weighted cash flows. The probability of the outcomes would be determined by reference to the risk neutral transition matrix. 

The reduced form models described earlier models are a new generation of credit derivative pricing models, which are now increasingly being used to price total return swaps. 

An investor should be able to replicate the index and its performance with a small number of instruments as well as with relatively low transaction costs and without moving the market too much. For this reason the index constituents should be a set of bonds that have standard features, are liquid, and trade actively in the secondary market. The ability to invest in the index through derivative instruments such as futures and total return swaps is an added attraction of an index. 

In capital structure arbitrage, investors exploit yield mismatches between two loans from the same reference entity. Say an issuer has two debt instruments outstanding a commercial bank loan paying 330 basis points over LIBOR and a subordinated bond issue paying LIBOR plus 230 basis points. This yield anomaly can be exploited with a total return swap in which the arbitrageur effectively purchases the bank loan and sells the bond short. 

FIGURE 10.6 Total Return Swap Used in Capital Structure Arbitrage ... 

FIGURE 10.7 Usin a Total Return Swap to Fund a Ssnurify Party A Asset seller, a hedge fund Party B Funds provider, an investment bank... 

For instance, bank loans are often deemed unattractive as investments because of the administration that managing and servicing a loan portfolio requires. Investors can acquire exposure to bank loans returns while avoiding the administrative costs through, say, a total return swap. The same transaction allows banks to distribute their loan credit risk. 

FIGURE 10.9 Using a Total Return Swap to Fund a Security... 

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