Loading the player...

What is a 'Total Return Swap'

A total return swap is a swap agreement in which one party makes payments based on a set rate, either fixed or variable, while the other party makes payments based on the return of an underlying asset, which includes both the income it generates and any capital gains. In total return swaps, the underlying asset, referred to as the reference asset, is usually an equity index, loans or bonds. The asset is owned by the party receiving the set rate payment.

BREAKING DOWN 'Total Return Swap'

Total return swaps allow the party receiving the total return to gain exposure and benefit from a reference asset without actually owning it. These swaps are popular with hedge funds because they get the benefit of a large exposure with a minimal cash outlay. The two parties involved in a total return swap are known as the total return payer and the total return receiver.

Mechanics of Total Return Swaps

In a total return swap, the party receiving the total return receives any income generated by the asset and benefits if the price of the asset appreciates over the life of the swap. In return, the total return receiver must pay the asset owner the set rate over the life of the swap. If the asset's price falls over the swap's life, the total return receiver will be required to pay the asset owner the amount by which the asset has fallen in price. In a total return swap, the receiver assumes systematic, or market, risk and credit risk. Conversely, the payer forfeits the risk associated to the performance of the reference security, but takes on the credit exposure to which the receiver may be subject.

Total Return Swap Example

Assume that two parties enter into a one-year total return swap in which one party receives the London Interbank Offered Rate, or LIBOR, in addition to a fixed margin of 2%. On the other hand, the other party receives the total return of the Standard & Poor's 500 Index (S&P 500) on a principal amount of $1 million. If LIBOR is 3.5% and the S&P 500 appreciates by 15%, the first party pays the second party 15% and receives 5.5%. The payment is netted at the end of the swap with the second party receiving a payment of $95,000, or ($1 million x 15% - 5.5%).

Assume the S&P 500 falls by 15%, rather than appreciating by 15%. The first party would receive 15% in addition to the LIBOR rate plus the fixed margin. The payment netted to the first party would be $205,000, or ($1 million x 15% + 5.5%).

RELATED TERMS
  1. Swap

    A derivative contract through which two parties exchange financial ...
  2. Bilateral Netting

    The process of consolidating swap agreements between two parties ...
  3. Bond Market Association (BMA) Swap

    A type of swap arrangement in which two parties agree to exchange ...
  4. Equity Swap

    An exchange of cash flows between two parties that allows each ...
  5. Forward Swap

    A swap agreement created through the synthesis of two swaps differing ...
  6. Asset Swap

    Similar in structure to a plain vanilla swap, the key difference ...
Related Articles
  1. Managing Wealth

    An In-Depth Look At The Swap Market

    The swap market plays an important role in the global financial marketplace; find out what you need to know about it.
  2. Trading

    An Introduction To Swaps

    Learn how these derivatives work and how companies can benefit from them.
  3. Trading

    Different Types of Swaps

    Investopedia explores the most common types of swap contracts.
  4. Trading

    How Are Interest Rate Swaps Valued?

    When trading in financial markets, higher returns are generally associated with higher risk. Hedge your risk with interest rate swaps.
  5. Investing

    What's an Interest Rate Swap?

    An interest rate swap is an exchange of future interest receipts. Essentially, one stream of future interest payments is exchanged for another, based on a specified principal amount.
  6. Investing

    Understanding Total Return Swaps

    A total return swap is a contract in which a payer and receiver exchange the credit risk and market risk of an underlying asset.
  7. Trading

    Currency Swap Basics

    Find out what makes currency swaps unique and slightly more complicated than other types of swaps.
  8. Investing

    How To Read Interest Rate Swap Quotes

    Puzzled by interest rate swap quotes terminology? Investopedia explains how to read the interest rate swap quotes
  9. Trading

    Hedging With Currency Swaps

    The wrong currency movement can crush positive portfolio returns. Find out how to hedge against it.
  10. Trading

    Interest Rate Swaps Explained

    Plain interest rate swaps that enable the parties involved to exchange fixed and floating cash flows.
RELATED FAQS
  1. What would motivate an entity to enter into a swap agreement?

    Learn why parties enter into swap agreements to hedge their risks, and understand how the different legs of a swap agreement ... Read Answer >>
  2. Can individual investors profit from interest rate swaps?

    Find out how individual investors can speculate on interest rate movements through interest rate swaps by trading fixed rate ... Read Answer >>
  3. What are interest rate swaps on the OTC market?

    Learn about interest rate swaps and how they are traded over the counter, and understand the impact of Dodd-Frank on swaps ... Read Answer >>
  4. Do interest rate swaps trade on the open market?

    Learn how interest rate swaps are traded on the OTC and interbank markets, and how these swaps can be used to arbitrage different ... Read Answer >>
  5. What is the difference between derivatives and swaps?

    Find out more about derivative securities, swaps, examples of derivatives and swaps, and the main difference between derivative ... Read Answer >>
  6. What is an absolute rate?

    An absolute rate is easy to understand once you know the basics of an interest rate swap. An absolute rate is the fixed rate ... Read Answer >>
Hot Definitions
  1. Cover Letter

    A written document submitted with a job application explaining the applicant's credentials and interest in the open position. ...
  2. 403(b) Plan

    A retirement plan for certain employees of public schools, tax-exempt organizations and certain ministers. Generally, retirement ...
  3. Master Of Business Administration - MBA

    A graduate degree achieved at a university or college that provides theoretical and practical training to help graduates ...
  4. Liquidity Event

    An event that allows initial investors in a company to cash out some or all of their ownership shares and is considered an ...
  5. Job Market

    A market in which employers search for employees and employees search for jobs. The job market is not a physical place as ...
  6. Yuppie

    Yuppie is a slang term denoting the market segment of young urban professionals. A yuppie is often characterized by youth, ...
Trading Center