Business and Personal Finance Dictionary

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• TOTAL RETURN SWAP
  
  Definition: The synthetic purchase of risky debt with 100% leverage. One of the counterparties receives (and the other pays) the excess of the risky debt’s total rate of return (interest plus capital gain) over LIBOR. A swap that has a floating payment that depends on the value of the remaining payments, hence depends on how likely it appears that the payer will make good its promise to pay. Examples: A counterparty in a junk bond swap receives the total rate of return on a portfolio of junk bonds and pay LIBOR. A bank loan swap might pay the total rate of return on a risky bank loan and receive LIBOR. In particular, Bankers Trust has offered swaps that pay the return on loans that fund the merger of Ralph’s Supermarkets and Yucaipa Companies’ Food 4 Less (Derivatives Week, 11/7/94). A counterparty might receive the total return on some risky corporate bond and pay LIBOR minus a fixed spread. Application: See Credit Derivatives. Pricing and Risk Management: The replicating portfolio for Total Return Swap is the levered purchase or sale. Consequently, its value is the value of the replicating portfolio, and its hedge is the sale of the replicating portfolio. Thus, the dealer providing this swap could hedge his position by buying the risky corporate bond and financing the purchase with a floating-rate loan. Comment: Why doesn’t the customer just do this, directly? The customer may not be able to deal with counterparties with low credit ratings. The dealer might have a higher credit rating. Of course, this looks like a way around regulations.
  
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