| Total Return Swaps 101 |
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| 26/11/2006 | |
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Martin Bertsch, from Lehman Brothers Product Development and Structuring Group, defines Total Return Swaps. Total Return Swaps are bilateral agreements in which two counterparties can agree on all terms of the contract and specify the following according to their requirements: · Underlying · Maturity · Currency · Notional · Type of Settlement (Cash vs. Physical Settlement) Total Return Swaps are simple to use and have low administration and transaction costs. They offer a high degree of flexibility, and do not require direct holding of an underlying. Mechanics of Total Return Swap  Total Return Swaps: An Alternative to Futures Futures are widely used within portfolio management for both Equity as well as Fixed Income portfolios. Some of them offer high liquidity, so that investors can easily increase / decrease exposure to the markets for large notionals. Futures however only exist on a limited number of underlyings. Furthermore, the benchmark the client has in his portfolio often does not exactly match the benchmark on the future. Futures purchase also requires replication which can result in a tracking error. Total Return Swaps also enable investors to combine Equity and Fixed Income. Most of the time investors use the Lehman Brothers Fixed Income or MSCI Equity indices as benchmarks. No futures are offered on either of the indices, but both of them are used for Total Return Swaps. Total Return Swaps thus constitute a good alternative to futures. Cashflows payable under a Total Return Swap In the following example we will assume that two counterparties will enter into a 1 year Total Return Swap on 100 000 X-Shares with a current market value of USD 50 against receiving USD Libor. Number of X-Shares: 100 000 Price of share X: USD 50 1 year Libor: 5%  Variation 1: Cashflows after 1 year Price of X share: USD 55 A receives: USD 5 * 100 000= USD 500 000 A Pays: USD 5mn * 5% = USD 250 000  Variation 2: Cashflows after 1 year Price of X share: USD 45 A receives: USD (-5) * 100 000 = USD – 500 000 A Pays: USD 5mn * 5% = USD 250 000  Application of Total Return Swaps Example 1 Let us consider the case of an investor who would like to gain exposure to the Lehman Brothers Global Aggregate Index. As the Index is based on a large amount of Bonds, managing a portfolio that closely tracks this index can be difficult. In order to simplify the management of the portfolio and to keep the tracking error minimal, the assets are invested into money market yielding Libor and then into a Total Return Swap that provides exposure to the Lehman Brothers Global Aggregate Index.  Example 2 An Investor has invested into the Equity Market and would like to enhance this exposure by the Alpha generated by a Fund of Hedge Funds. The investor enters into a Total Return Swap linked to the Fund of Hedge Funds. Through the Total Return Swap the investor receives the performance of the Fund of Hedge Funds against paying Libor. In this example, we assume that the benchmark of the Fund of Hedge Fund is Libor.  Example 3 A corporate investor is looking to increase his exposure to company X. The corporate investor does not want to have a direct ownership in shares of Company X, but would like to have synthetic exposure to the company through a Total Return Swap. The rationale for indirect exposure to the company can be driven by: · Cost of funding · Regulatory and tax considerations · Flexibility Documentation of Total Return Swaps Total Return Swaps, like most other Derivatives, are documented following standard derivatives documentation based on ISDA definitions. The International Swaps and Derivatives Association (ISDA) is a voluntary consortium of major derivative players that created and maintain a standard derivative contract. Counterparty Risk and Total Return Swaps A Total Return Swap is a bilateral agreement between two counterparties. When the exchange of the payments between the two counterparties occurs e.g. after 1 year, both counterparties might have a credit exposure against the other in case of a default. In order to mitigate this risk, it is common that collateral agreements are set up. A collateral agreement is a bilateral agreement whereby both counterparties agree that they will post additional cash or securities in case of market movements of the underlyings. The amount that will be posted is mostly based on the Mark to Market of the Swap. |
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