Credit Derivatives: Trading, Investing and Risk Management, Second Edition

16

Total Return Swaps

16.1 PRODUCT DEFINITION AND EXAMPLES

A total return swap (TRS) is an off-balance transaction in which the ‘payer’ pays the ‘receiver’ the total return on a reference asset (be it positive or negative) from the effective date to the ‘fixing’ date in return for a floating leg, usually LIBOR plus a spread. Cashflows - such as coupon payments - are usually paid to the receiver on the dates the reference asset makes those payments. A TRS may be arranged with several intermediate fixing dates before maturity. In this case usually the terms of the TRS may be the same as if each sub-period was a TRS in its own right done at fair market terms, effectively terminating and restarting a new TRS at each fixing date. We shall only consider a TRS with a single total return payment date.

The payer is often called the buyer of protection, as the TRS will compensate the payer for negative performance of the reference assets. If the asset declines in price, the payer pays a negative amount to - i.e. receives a payment from - the receiver. In particular if the asset defaults, a large payment is made by the receiver to the payer, and the contract terminates with a proportionate floating payment from the receiver.

Similarly, a receiver of the total return is often called a seller of protection, as the swap will expose him or her to negative performance of the reference assets.

On default of the underlying settlement can be cash or physical.

Counterparty risk is initially ...