Total Return Swap
Total Return Swap or TRS is a swap agreement between two counterparties, a buyer (also known as the index receiver) which will receive payments from an underlying (a stock, an index, a bond, etc) and will pay a floating amount based on a floating interest rate (EONIA, LIBOR, etc). On the other hand, the seller (also known as the index payer) will pay the index returns (only if there are positive ones) and will receive the floating rate.
Total Return Swap is implemented with two legs:
-Equity leg (or index leg)
-Rate leg (floating leg)
Total Return Swaps are widely used as a hedging tool by asset managers. For example, a fund manager who is long of all the EUROSTOXX index components could sell a TRS on SX5E, meaning that he will pay (if the SX5E underlying price rose) or receive (if the SX5E underlying price slip) the returns on the index and on the other hand, he will receive the floating rate payment (if the floating rate with spread is positive). Then, in this case, the fund manager will be hedged on its long position on the SX5E components, and additionally, he will receive a payment from the floating rate. Moreover, using a TRS gives the buyer the advantage of receiving the underlying capital gains as well as the dividends paid during the TRS lifespan without owning the underlying. Indeed, the underlying is detained by the TRS seller (Index payer). To compensate for this drawback for the TRS seller, the buyer will pay the floating rate (except if the reference rate with the spread is negative). Let’s take a simple example, two counterparties, Bank X (TRS seller) with fund manager Y (TRS buyer), enter a 1Y TRS (in January 2021) on the SX5E index. The notional amount is 1,000,000 EUR and the floating rate is EONIA + 0.2% (assume EONIA is 0.4%). At the end of the year (January 2022), if the SX5E index rose 10%, the fund manager Y will receive ((10% – 0.6%) * 10,000,000) = 940,000 EUR which represent the capital gain on the SX5E (assume no dividend in this case) minus the floating rate of 0.6% paid to the seller.