# Understanding Total Return Swaps: Definition, Function, and Examples

![Total Return Swap](https://www.investopedia.com/thmb/pBOxR5-HoANK40ZIoEJXAGHm3sc=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/Totalreturnswap-Final-a8870a0d2e504d4d85a07eb13ad70ccf.jpg)

*— Investopedia / Michela Buttignol*

## What Is a Total Return Swap?

A Total Return Swap (TRS) is a financial derivative that enables one party to receive payments based on a set rate, while the other gains from the total return of a reference asset, such as an equity index, a basket of loans, or bonds. The party receiving the asset's return benefits from any income and capital appreciation without owning the asset, making TRS popular among hedge funds. In contrast, the party making the set rate payments effectively transfers the asset's market and credit risks to the return receiver.

### Key Takeaways

*   A Total Return Swap (TRS) is an agreement where one party pays a set rate, while the other receives payments based on the return of a referenced asset, including income and capital gains.
*   Total Return Swaps allow exposure to assets like equity indexes or bonds without ownership, making them attractive to hedge funds for achieving large exposure with minimal cash outlay.
*   In the event of asset depreciation, the total return receiver bears the loss and pays the asset owner, assuming market and credit risks.
*   The swap structure enables the payer to avoid performance risk but involves taking the receiver's credit risk.

## How Total Return Swaps Provide Asset Exposure

A total return swap lets the receiver benefit from a reference asset without owning it. These swaps are popular with hedge funds because they provide the benefit of a large exposure to an asset with a minimal cash outlay. The two parties involved in a total return swap are known as the total return payer and the total return receiver.

A total return swap is similar to a bullet swap; however, with a bullet swap, payment is postponed until the swap ends or the position closes.

## Obligations and Risks in Total Return Swaps

The total return receiver collects income from the asset and benefits if its price rises during the swap's duration. In exchange, the total return receiver must pay the asset owner the set rate over the life of the swap.

If the asset's price 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 a total return swap, the receiver assumes systematic, or market, risk and credit risk. Conversely, the payer avoids asset performance risks but takes on the receiver's credit exposure.

## Illustrative Example of a Total Return Swap

Assume that two parties enter into a one-year total return swap in which one party receives the [London Interbank Offered Rate (LIBOR)](https://www.investopedia.com/terms/l/libor.asp) in addition to a fixed margin of 2%. The other party receives the total return of the Standard & Poor's 500 Index (S&P 500) on a principal amount of $1 million.

After one year, if LIBOR is 3.5% and the S&P 500 appreciates by 15%, the first party pays the second party 15% and receives 5.5%. The payment is netted at the end of the swap with the second party receiving a payment of $95,000, or \[$1 million x (15% - 5.5%)\]. 

Conversely, consider that rather than appreciating, the S&P 500 falls by 15%. The first party would receive 15% in addition to the LIBOR rate plus the fixed margin, and the payment netted to the first party would be $205,000, or \[$1 million x (15% + 5.5%)\].

> **Article Sources**
>
> 1.  Bloomberg Professional Services. "[Total Return Swaps 101](https://www.bloomberg.com/professional/blog/total-return-swaps-101/)."