Applications
Total return swaps have four uses: hedging, leverage, market access, and balance sheet management
Total return swaps have four general uses. They are used to:
1. Enter into hedge or "short" positions. Investors can pay "total return" on an asset or basket of assets to obtain an off-balance sheet, term short position.;
2. Obtain leverage. The list of eligible assets for total return swaps is more extensive than bank-financeable assets and includes some illiquid assets such as offshore hedge funds and private placements;
3. Access markets efficiently. Total return swaps on corporate bank loans allow non-banks to enter the loan market without establishing elaborate and costly funding and processing operations; and
4. Improve return on capital and manage balance sheet usage. Total return swaps are off balance sheet instruments for GAAP purposes. As such, any positive return on a total return swap enhances return on GAAP equity since only the mark-to-market value, if positive, is an on balance sheet asset.
Examples
Leveraged investment in a fund. Investors can enter into a total return swap on an investment or sector fund. The investor receives all the cash flows from the fund and enhances returns through the use of leverage.
Synthetic repo. A money manager that anticipates spread tightening lacks current liquidity with which to fund investments. By receiving total return on one or more corporate bonds, the money manager can lock in the purchase price of assets while minimizing capital commitments, thereby disaggregating market timing from liquidity constraints.
Synthetic CBO. Investors can in effect create their own customized
collateralized bond obligation by entering into a total return swap on a basket of high yield bonds. The investor would choose the bonds and may be required to post initial margin in the form of cash collateral or securities. Merrill Lynch can provide an out of the money "put" on the basket that limits the investor's loss to the initial margin amount. The net effect is similar to the leverage and limited risk inherent in an equity tranche in a CBO. The advantages of this transaction are its ease of setup, the ability of the counterparty to alter the bonds in the swap (subject to certain limitations), and the ability of the investor to customize the structure (size, put strike, fixed or floating funding).
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