30. Total return swaps (TRS) are bilateral financial contracts designed to synthetically replicate the economic returns of an underlying asset or a portfolio of assets for a pre-specified time. As illustrated in Figure 7, one counterparty (the TR payer) pays the other counterparty (the TR receiver) the total return of a specified asset, the reference obligation. In return, the TR receiver typically makes regular floating payments. These floating payments represent a funding cost. In effect, a TRS contract allows the TRS receiver to obtain the economic returns of an asset without having to fund the assets on its balance sheet. As such, a TRS is a primarily off-balance sheet financing vehicle.

Total Return Swap

31. When the underlying obligation is a fixed income instrument, the total return payment would consist of interest, fees (if any), and any change in the reference obligation's value. Any appreciation or depreciation in the reference obligation's value is typically determined on the basis of a poll of dealers. TRS contracts can specify that change-in-value payments be made either on a periodic interim basis (which will reduce the credit risk between the two parties to the contract) or at maturity.

32. Should the underlying asset decline in value by more than the coupon payment, the TRS receiver must pay the negative total return, in addition to the funding cost, to the TRS payer. At the extreme, a TRS receiver can be liable for the extreme loss that a reference asset may suffer following, for instance, the issuing company's default.

33. In instances when change-in-value payments are to be made at the maturity, the change-in-value payment is sometimes physically settled. In such cases, the TR payer physically delivers the reference obligation to the TR receiver at the maturity of the TRS contract in return for cash payment of the reference obligation's initial value.

34. Because a TRS frequently requires periodic exchanges of cash flows based in part on a mark-to-market of the underlying asset, TRS typically reference liquid, traded assets. When illiquid assets are referenced, alternate pricing arrangements are used.

35. A TRS's reference obligation can be a single asset-such as a particular bond or loan-or an index or basket of assets. TRS that reference baskets of credits or indices are becoming increasingly common due the cost-effective access they provide to portfolios of credit risk. That is, index-based TRS provide investors with their desired portfolio exposure while eliminating the cost of executing a large number of individual cash transactions to obtain it.

36. The maturity of the TRS does not have to match the maturity of the reference obligation, and in fact is usually shorter than the maturity of the underlying asset. Though shorter in maturity, the TRS receiver is naturally exposed to full duration exposure of the underlying asset. In a number of instances, TRS are drafted to allow either party to cancel the transaction at the anniversary date of the contract. In most instances, TRS referencing a single name typically terminate upon default of the underlying asset or other such defined credit events. At such time, the asset can be delivered and the price shortfall paid by the TR receiver. A TRS can continue despite default or other credit event if the TR receiver posts the necessary collateral.

37. In contrast to credit default swaps-which only transfer credit risk-a TRS transfers not only to credit risk (i.e. the improvement or deterioration in credit profile of an issuer), but also market risk (i.e. any increase or decrease in general market prices). In addition, TRS contrast with CDS in that payments are exchanged among counterparties upon changes in market valuation of the underlying, not only upon the occurrence of a credit event as is the case with CDS contracts.

38. TRS pricing is based on a dealer's cost to fund its hedge. Generally speaking, a static hedge would consists of a TR payer's cost of purchasing the asset at trade inception, funding and servicing the asset on balance sheet for the duration of the transaction, and selling the asset at trade maturity. As such, the cost of the trade depends mainly on the funding cost of the TR payer and any regulatory capital charges incurred. A TRS payer's funding cost is naturally a function of its creditworthiness/rating. A regulatory charge in turn-assuming a bank is the TR payer-depends on the BIS risk weightings of the reference obligation.

39. Secondarily, TRS pricing also needs to account for counterparty risk and repo financing (if available) for the reference obligation. A TRS payer can either seek to be compensated for the counterparty risk-that is, the possibility that a TR receiver might default on its payments-by either charging a higher funding cost, or more typically, by requiring collateral to be posted.

40. Naturally, perfect hedges are not always available. In those instances, TRS pricing also needs to include additional compensation for the basis risk borne by the TRS payer arising from the imperfect hedge.