Total return swaps allow two parties to exchange the cash flows of an asset. These cash flows include periodic flows (interest, dividends and fees) as well as price change (appreciation/depreciation). The "long" party (below, "Counterparty") in a total return swap has the same cash flows as if they owned the asset directly
Total return swaps can be executed on most asset types including corporate bank loans (term and revolver), corporate bonds, equities, emerging market securities, mutual funds, hedge funds and private equity funds, and indices of all types. This section will focus on total return swaps on individual assets. The following section discusses total return swaps on bond indices.
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• trading level on the option start date, but tighter than the new market level. If the credit spread does not widen, the option expires worthless and the investor retains the fee.
• Creating positions that are difficult or risky to create in the cash markets.
Investors can "lock in" gains on appreciated bonds by purchasing a spread collar or create forward spread options by selling short tenor options and buying longer tenor options
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Credit spread option payments are triggered by price events rather than credit events A credit spread option is a financial contract that gives one party the right to buy or sell an underlying security at a variable price based on a predetermined spread (or strike) above a reference index (such as Treasuries or LIBOR). Credit spread options can be traded outright, or embedded in callable and putable asset swaps
Credit spread options have a higher likelihood of exercise than default swaps on the same bonds. A spread option written with an out-of-the-money strike begins to resemble a default swap with respect to the likelihood of exercise. However, the magnitude of the economic loss when a written spread put option is exercised is lower on average. For example, if an investor writes a spread put option that gives Merrill Lynch the right to "put" an 8.5 year non-investment grade bond to them at a price equivalent of Treasuries + 300 bps, and the bond subsequently trades at T + 400, the investor has an economic loss equal to the present value of 100 bps for 8.5 years (approximately 5.8% today). This is a much smaller loss than one would expect upon exercise of a swap conditioned upon the occurrence of an event of default. In this case, the average loss on senior unsecured bonds would be 52%, according to Moody's.
Both credit spread options and default swaps exist because of different investor preferences. Some investors are more averse to the likelihood of the occurrence of any loss, regardless of its size. Others concentrate on the magnitude of the possible loss versus the potential trade profit. While a credit spread option and a default swap may have the same expected gain (fee collected minus probability of a loss multiplied by the magnitude of a loss), investors may not be indifferent to the structures.
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