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, a basket of loans, or bonds. The asset is owned by the party receiving the set rate payment.

Understanding Total Return Swaps

A total return swap allows 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 provide the benefit of a large exposure to an asset 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.

A total return swap is similar to a bullet swap; however, with a bullet swap, payment is postponed until the swap ends or the position closes.

Requirements for Total Return Swaps

In a total return swap, the party receiving the total return collects any income generated by the asset and benefits if the price of the asset appreciates over the life of the swap. In exchange, 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 a total return swap, the receiver assumes systematic, or market, risk and credit risk. Conversely, the payer forfeits the risk associated with the performance of the referenced 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 (LIBOR) in addition to a fixed margin of 2%. The other party receives the total return of the Standard & Poor's 500 Index (S&P 500) on a principal amount of $1 million.

After one year, 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%)]. 

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