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Total Return Swap (TRS) PART 5

Author: Financial-edu.com


Risks of Total Return Swaps

Investment Return Risk
is born by the Total Return Receiver in a Total Return Swap.  While the Total Return Payer retains the reference asset(s) on its balance sheet, the Total Return Receiver assumes the risk of capital losses by making guarantee payments to the Total Return Payer that offset any drop in asset value.

Interest Rate Risk is born by both parties to a TRS.  Payments made by the Total Return Receiver to the Total Return Payer are normally floating rate LIBOR +/- a spread.  If LIBOR increases during the life of the TRS, the Total Return Receiver's coupon payments will increase.  If LIBOR decreases, the Total Return Payer's coupon receipts will decrease.  Interest Rate Risk is typically higher to the investor (TRR) who does not necessarily have direct access to LIBOR financing, whereas the bank (TRP) does.  The TRR may therefore need to hedge its LIBOR risk through the use of interest rate derivatives such as FRAs, caps, floors, and futures.

Liquidity Risk may exist if the TRS terms specify physical delivery of assets between the parties.  For example, if the TRS requires the bank (Total Return Payer) to deliver specific high yield bonds at expiration, and these bonds defaulted during the life of the TRS, it may be difficult to acquire them at reasonable valuation in the open market if the bank does not have them in its inventory. If the TRS reference asset is a mortgage or credit card loan, the obligor may have prepaid and retired its loan earlier than expected prior to the expiration of the TRS, requiring the bank to purchase a substitute loan or make a cash payment on the estimated present value of a loan retired in the past. Illiquid instruments are also difficult to mark to market, since there is a lack of comparative transaction data.  This can cause valuation disagreements between the counterparties and interfere with efficient settlement.

Counterparty Risk can be a significant factor in certain transactions.  Many hedge funds (Total Return Receivers) take leveraged risk to generate greater returns.  If a hedge fund makes multiple TRS investments in similar assets, any significant drop in the value of those assets would leave the fund in a position of making ongoing coupon payments plus capital loss payments against reduced or terminated returns from the asset(s).  Since most swaps are executed on large notional amounts between $10 million and $100 million, this could put the Total Return Payer (typically a commercial or investment bank) at risk of a hedge fund's default if the fund is not sufficiently capitalized.  Hedge fund counterparty risk is accentuated due to secrecy and minimal or nonexistent balance sheet reporting obligations.  Counterparty risk may be ameliorated by shortening the maturity of the TRS, increasing collateral required, or third party balance sheet auditing and verification.

Bankruptcy Risk may exist where the reference asset is a single large capital asset, such as a industrial building mortgage or airplane loan.  If the borrower defaults or files for bankruptcy, the loan payments may terminate, effectively eliminating the asset returns to the Total Return Receiver and requiring large capital loss payments to the Total Return Payer.

Total Return Swap Documentation

Total Return Swaps are documented using a standard International Swaps and Derivatives Association (ISDA www.isda.org) Master Agreement and Schedule, which governs swaps between two parties. 

There is an additional Credit Support Annex (CSA), where the parties set forth the agreed collateral and credit terms.  These terms are often unique.

The Swap Confirmation ("Confirm") is usually a customized document.  The Confirm sets the actual trade terms of the TRS, which may vary widely depending on the reference asset(s) and parties.  Counterparties with regular trading relationships often develop their own templates to speed transaction processing and ensure both parties clearly understand their payment obligations.

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