Total Return Swaps
In a total return swap (abbreviated TRS in the United States, TRORS in Europe), a note/loan owner, usually a bank, transfers the entire risk and reward of the note to another party (usually a hedge fund) in exchange for a defined fixed or floating rate return.
In the example shown in Figure 6.1, a bank that borrows floating dollars and lends fixed rate pounds is exposed to three risks:
In this example, the credit risk is that the money the bank lent to the UK customer might not be repaid on time or in full. The interest rate risk comes from the fact that the bank is receiving a fixed rate on its loan—but is paying a floating rate on its funding. This exposes it to the risk that US$ LIBOR rates rise. The FX risk comes from the fact that the bank is borrowing US$ and lending UK£. The bank is exposed to the risk that the USD will strengthen.
Basic Total Return Swap
After entering into a TRS with a hedge fund, the bank locks in a 100 bps return by swapping the total return from the loan for US$ LIBOR + 100 bps, which is 100 bps above its cost of funding. This replaces the three risks in the loan with one risk—the counterparty risk of the hedge fund. As shown in Figure 6.2, this is the risk that the hedge fund will be unable to meet its commitment under the terms of the TRS.
FIGURE 6.2
Bank Laying Off Risk with a Hedge Fund
To offset this counterparty risk, the hedge fund usually:
Requiring the 10% security deposit on each of the transactions ensures that the bank has enough collateral to fully protect itself from counterparty risk on the first loss, even if the recovery is zero. Ideally, the issuers that are swapped by the bank in the 10 TRS have a low correlation, so it is unlikely they will all go bad at the same time. For further protection, when the transactions are marked to the market, the hedge fund puts up more collateral (even if the notes are still paying) in the event that the value of the notes declines due to deterioration risk.
By entering into the transaction with a hedge fund, the bank locks in a 100 basis point spread over its cost of funding. Note that the total return arrow has two heads. If the note generates a positive return, the bank pays the hedge fund the net difference between the total return and $LIBOR + 100. If the return is negative, the hedge fund pays the bank the loss in addition to paying $LIBOR + 100.
The hedge fund hopes that the return from the note consistently exceeds $LIBOR. In this example, the hedge fund benefits if:
If, collectively, these three changes offer a higher reward than risk, the hedge fund will always be the net recipient of the quarterly payment. The hedge fund further benefits from the leverage that a 10% security deposit allows. Figure 6.3 diagrams the swap at inception and in 3 years after US interest rates have declined by 3% and the dollar weakens by 20%.
FIGURE 6.3
TRS Return on Collateral
An 87% return on the security deposit (which is raised from investors) leaves plenty of money to offer investors a great return, even after the hedge fund managers take their 2% fee and 20% bonus.