Total Return Swap
AdvancedA total return swap is a derivative in which one party pays the total return of an asset, including income and changes in value, to the other party in exchange for a set of payments, usually a floating interest rate plus a spread.
A total return swap lets one party gain the economic exposure of owning an asset without actually buying it, while the other party, which may own the asset, passes on its returns and risks.
For example, a hedge fund enters a total return swap with a bank on a share portfolio worth 10,000,000. The bank pays the fund any dividends and price gains on the portfolio, and the fund pays the bank a floating rate, such as SOFR plus 1%, plus any price losses on the portfolio.
The fund gets exposure to the shares without paying the full price upfront, effectively using leverage. The bank earns a financing return and may hedge by holding the shares.
Total return swaps are used for financing, gaining exposure to hard-to-access assets and managing risk. They can also hide the true size of investors' positions. The collapse of the family office Archegos Capital in 2021, which had built huge concentrated positions through total return swaps with several banks, caused billions of dollars of losses for those banks and led to calls for greater transparency.
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