Total Return Swap - OTC Product

Total Return Swap - Product use to transfer your credit and market risk and used for getting leverage in the market. How its used and how does it work , lets learn with an example as it diff to understand without it.

Firstly, its a OTC product where one party pays performance of the underlying security in exchange for a floating rate, usually LIBOR and a spread. Total Return Swap can be used in various different ways, with various types of securities as underlying security, be it equity shares, bonds, banks loans, etc. The motivation and structure of the products is little different than other swaps namely Asset Swap , Equity Swap, Interest Swap or you can Credit Default Swap . .

Suppose I believe Company A has good chance of giving me good returns in short term and I want to invest into it . Current Price is $ 100. I want to invest 10 million dollars but I have only $2 million with me as Capital Due to some reason, I cant take debt on books of accounts of remaining $ 8 million to buy these bonds directly. So what should I do?

I go to my good old friend , who is rich person and tell him my situation. He has the opposite outlook for the company in short term and he holds Company A bonds of $10 million in his position . He is ready to give me leverage and to trade on each other analysis we can agree upon to enter into a TRS for 3 years , $10 million , settling all the amounts every 6 months and me giving $2 million as upfront capital as margin( protection money) . As per the TRS agreement , I will give my friend LIBOR rate on $ 10 million plus a spread (this is more based on my riskiness) and in return my friend would pay all the returns on the Company A in terms of price appreciation as well any Interest paid by Company A .

I am the Total Return Receiver and my friend is Total Return Payer. Synthetically for me its like owning the exposure of Company A without actually owning the Bonds in my balance sheet. If the price rises, I am to benefit , if the price falls I need to pay my friend.

For my rich friend, though he would report the bonds in his balance sheet as he is actual owner in the market, but via derivative contract , he is given across his credit and market risk exposure to me for a short terms. If the value of the bond falls, I will pay. If the bond defaults, again I will have to pay him.

In the example I gave you above , my friend had a bond position . In some cases, it can be scenario my friend may not have the bonds and buy from the market by taking a loan from his network of $10 million may be at lesser rate what ill be paying him, that is LIBOR + spread and his profit is the diff between the rate I am paying vs the rate he is paying for the loan.

TRS can also be used as part of financing, where if I hold the bonds, I sell to my friend, he lends me money as part of financing based on the bonds, something like how a Repo transaction works , regulations can differ though.

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