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Total Return Swap (TRS) PART 4


TRS Similarities to Other Derivatives

In standard format, a TRS somewhat resembles a Credit Default Swap (CDS).  Both a TRS and CDS are off-balance sheet and relate to the potential for default if the TRS reference asset is a loan or bond.  As a result, a TRS is often characterized as a credit derivative.  However, a TRS protects against loss in asset value (not necessarily related to default), while a CDS only protects against loss caused by specific credit default events. TRS also has non-standard terms, whereas a single name CDS normally follows standard ISDA documentation. 

A TRS may resemble a Collaterized Debt Obligation (CDO) Tranche. In a CDO the investor takes an equity position in a fixed income reference portfolio, just as the TRS Total Return Receiver may take a synthetic position in fixed income reference asset(s).  However, a TRS differs in the fact that it has complete flexibility in portfolio structure, terms, maturity, and unwinding mechanism.  A TRS is inherently off-balance sheet for the Total Return Receiver whereas a CDO, CBO, or CLO investment usually is not.  A TRS has exposure to the total returns of all reference assets compared to a CDO investment, which has exposure only to the particular tranche (Super Senior, Senior, Mezzanine, Junior/Equity). 

A TRS is similar to a Vanilla Interest Rate Swap if the TRS reference asset is a loan or bond.  However, in an Interest Rate Swap, the spread charged to account for differences in the expected future value of the interest payment legs includes the risk of default on the underlying fixed income instruments.  In a TRS, the Total Return Receiver pays LIBOR +/- a spread, with the spread amount unrelated to the potential default on the reference asset(s) since that is treated separately in the capital depreciation payments.  Furthermore, in an Interest Rate Swap, only the net interest payments are exchanged, whereas in a TRS the total returns of the reference asset(s) are exchanged.

TRS Valuation and Cash Flows

A Total Return Swap (TRS) is initially structured so the Net Present Value (NPV) to both parties is at or close to zero.  As time progresses, the TRS gains or loses value on each leg so one or the other counterparty obtains a profit.

Payments Received by Total Return Receiver:
- If reference asset is a bond, the bond coupon
- The price appreciation, if any, of the reference asset since the last fixing date
- If the reference asset is a bond that defaulted since the last fixing date, the recovery value of the bond
- Interest on any collateral / haircut being held by the Total Return Payer

Payments Received by the Total Return Payer:
- The periodic floating payment (usually LIBOR +/- a spread)
- The price depreciation, if any, of the reference asset since the last fixing date
- If the reference asset is a bond that defaulted since the last fixing date, the par value of the bond

The cash flows above are typically netted and exchanged in a single payment.  If the counterparties have multiple trades together and are operating under a netting agreement, then the net cash flows from the TRS may be netted out with other trades and a single payment made covering all trades.

Benefits of Total Return Swaps

The greatest benefit of a TRS is leverage.  The parties do not transfer actual ownership of the assets, as occurs in a repo transaction.  This allows reduced up-front capital to execute a valuable trade.  This makes Total Return Swaps a favorite of hedge funds. 

A TRS can be used as a synthetic funding instrument offering improved financing costs.  For example, engaging in a repo transaction might cost LIBOR at 5.75% plus 125bp plus transaction fees of 0.25% plus bid/offer spread of 5bp, for a total of 7.3% to a hedge fund.  A TRS may cost LIBOR at 5.75% plus 150bp spread to "lease" the bank's balance sheet assets, for a total of 7.25%.  In addition, the hedge fund may save 5bp in asset servicing costs, reducing the expected financing cost to 7.2%.

Operational efficiency is another benefit of a TRS, as settlements, interest collection, payment calculations, consent requests, reporting, and tracking associated with transferring ownership of an asset can be avoided.  Asset administration is left to the Total Return Payer so the Total Return Receiver never has to deal with these issues.

Total Return Swaps are highly flexible.  A TRS can be based on virtually any asset or series of assets. Furthermore, the life of a TRS contract and its payment dates are up to the parties, and need not match the payment or expiration dates of the reference asset(s).

Total Return Swaps can provide access to otherwise inaccessible asset classes, such as new issue loans, hedge fund limited partnership interests, private equity securities, etc.



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