A swap agreement in which one party makes payments based on a set rate, either fixed or variable, while the other party makes payments based on the return of an underlying asset, which includes both the income it generates and any capital gains. In total return swaps, the underlying asset, referred to as the reference asset, is usually an equity index, loans, or bonds. This is owned by the party receiving the set rate payment.
Total return swaps allow the party receiving the total return to gain exposure and benefit from a reference asset without actually having to own it. These swaps are popular with hedge funds because they get the benefit of a large exposure with a minimal cash outlay.
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Prior to 2008 hedge funds used a lot of total-return swaps which essentially is exactly the same thing as a contract
for difference (CFD
). By using a TRS the hedge funds could essentially side-step regulatory oversight and enter into positions without affecting the market. However, by trading off-exchange you have counterparty risk in that the person on the other side of the swap may not be able to make a payment.