Total Return Swaps (TRS), also called Total Rate of Return Swaps (TROR) 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. 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. 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.
As such, a TRS is a primarily off-balance sheet financing vehicle. 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 TRS payments are exchanged among counterparties upon changes in market valuation of the underlying, in addition to the occurrence of a credit event as is the case with CDS contracts.
A simple TRS structure looks like this:
