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TRS (total return swaps)

A TRS (also called a total rate of return swap) is a bilateral agreement where one party (the TRS payer) agrees to pay the other (the TRS receiver) the total return of a defined asset in return for receiving a stream of e.g. LIBOR based cash flows. It is a mechanism for the TRS receiver to enjoy the economic benefits of owning as asset without utilising the balance sheet. The TRS receiver is seeking returns on the asset without buying the asset.

Like a credit default swap (CDS), a TRS is also a bilateral financial contract designed to transfer credit risk between two parties. However, a TRS achieves this by exchanging the total economic performance of a specified asset for another cash flow. During the term, the TRS will cover any economic deterioration during that time as well as paying out any economic benefit or appreciation of the asset. In other words, the CDS provides protection against specific credit events whereas the TRS protects against loss of value irrespective of cause, whether default, widening of credit spreads or anything else.

The TRS payer swaps the total economic return of an asset for fixed or floating interest payments. TRS results in payments reflecting changes in the market valuation of a specified asset in the normal course of business whereas a CDS results in a contingent or floating payment only following a credit event. The asset can be indices, bonds, loans, equities or commodities.

TRS can be used by the TRS payer to hold an asset to maturity but may be uncomfortable with credit exposure of the asset for a certain period of time, and will therefore look to hedge the risk to reduce exposure. Reasons for maintaining ownership may include regulatory requirements and the need to maintain a relationship with the obligor. As with the CDS, TRS allows the TRS payer to hedge out the credit risk of an asset while retaining ownership.

The TRS is an off-balance sheet transaction. The asset stays on the balance sheet of the TRS payer and does not transfer to the balance sheet of the TRS receiver.

At the end of the TRS, the TRS receiver pays any decline (or receive any increase) in the value of the asset. The TRS receiver may agree that if the TRS is terminate due to a default of the asset, the TRS receiver will pay the difference between the price of the asset at the beginning of the transaction and at default. Alternatively, the TRS receiver may agree to take delivery of the asset and pay the initial price of the asset to the TRS payer.

The relevant provisions of a TRS can be found here.

derivativeslawyer.com

Last updated 14 February 2006

The above notes are intended to provide only general outlines and should be read in conjunction with, and are qualified in their entirety by, the full provisions of the relevant ISDA provisions and definitions. They should never be used in place of professional advice. We accept no responsibility for any loss arising from any action taken or not taken by anyone using this material or using this material in conjunction with any ISDA documentation in reliance thereof.

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