What is a Total Return Swap?

Total return swaps are a strategy in which each party receives some type of rate or return on a particular reference asset. Hedge funds are one of the more common types of financial investments that make use of this type of arrangement. The swap is usually classified as one form of a credit derivative, although the process is not an exact match for the usual working definition for this type of derivative.

In a total return swap strategy, one of the participating parties will receive interest payments on the hedge fund. Included with the interest payments are capital gains and losses for the period cited. The other party in the transaction will receive some sort of fixed or floating rate as compensation for participation. Usually, the floating rates are based on the current LIBOR. A spread that is predetermined between the parties at the time the deal is established helps to keep the balance between the partners within reasonable perimeters.

While a total return swap is sometimes understood to be a credit derivative, this is not the case, at least in the classic sense. A total return swap carries both credit and market risk. That is different from a traditional credit derivative where dual risk is not part of the structure or operation of the derivative.

Use of a total return swap is very common with hedge funds. It can help to create a degree of leverage with the reference assets used in the swap. Investors can benefit from one of two ways with the total return swap. One party will be able to enjoy the benefit of owning the asset without having to list it on a balance sheet. The other party does carry the assets on a balance sheet, but does have protection against any degree of loss on the reference asset.

Banks are a good example of investors who find the total return swap to be a good move. Because there is an attractive funding cost advantage, a bank can enjoy the benefits without the need to tie up much in the way of cash to acquire the reference asset.