What is a Total Return Swap?
In the financial markets, different rates are used for different transactions. One example of these interest rates is the total rate of return swaps (TROR). TROR are used for agreements to exchange the total return of a reference asset such as a risky corporate bond for a floating rate such as LIBOR plus a specified spread. This return rate will generally include both capital gains (or losses) and any flows (coupons, interest, dividends) over the life of the swap.
Examples of Total Return Swap:
Let’s take an example of the total rate of return swap. Let’s assume a payer who owns the reference asset, a total return swap would allow the owner to transfer the credit risk of the asset to the receiver. If the payer does not own the reference asset, a total return swap’s cash flows would be similar to those of taking a short position in the bond. If the value of the bond declines, the payer position gains. If the value of the bond increases, the payer’s position loses. Conversely, the cash flows to the receiver can be viewed as the total return on the reference asset, which is a floating rate obligation.