Total Return Swap

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, loans, or bonds. This is owned by the party receiving the set rate payment.

Total return swaps allow the party receiving the total return to gain exposure and benefit from a reference asset without actually having to own it. These swaps are popular with hedge funds because they get the benefit of a large exposure with a minimal cash outlay.

In a total return swap, the party receiving the total return will receive any income generated by the asset as well as benefit if the price of the asset appreciates over the life of the swap. In return, the total return receiver must pay the owner of the asset the set rate over the life of the swap. If the price of the assets 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 price.

For example, two parties may enter into a one-year total return swap where Party A receives LIBOR + fixed margin (2%) and Party B receives the total return of the S&P 500 on a principal amount of $1 million. If LIBOR is 3.5% and the S&P 500 appreciates by 15%, Party A will pay Party B 15% and will receive 5.5%. The payment will be netted at the end of the swap with Party B receiving a payment of $95,000 ($1 million x 15% - 5.5%).