Total Return Swap

i. We commenced our definition of a single-name credit default swap by asserting that the progressive differentiation of synthetic finance from generic finance signals an important phase transition in our dynamical system of economic institutions, with deep historical, materialist significance. And we briefly considered the ontology of a single-name credit default swap (CDS) to inaugurate our illustration of this truth. Another type of credit derivative called a total return swap (TRS) is more revelatory, still.

A TRS is a bilateral exchange between two parties –(a) a protection buyer, who periodically transfers or ‘swaps’ the ‘actual returns’ from some reference asset or index of assets to (b) a protection seller, who in return transfers the ‘total returns’ of some agreed-to amount, calculated at a certain spread over or below a benchmarked base rate of return.

On the one hand, cash flow from the actual returns derives from its synthetic replication of the returns and current market value of a generic financial asset or index of assets: this includes replicating any discounts or coupons, and ongoing market appreciation/depreciation in the value of the generic referent. On the other hand, cash flow from the total returns is tethered to a base rate –e.g. LIBOR + X bps– agreed to by the parties to the TRS ahead of time [figure 2.2].[1] This means that cash flows from the total returns and the actual returns are both ostensibly derived from the returns and current market value of the same generic referent, since the total returns is a reflection of the spread between the actual returns, less the benchmarked base rate of return.

For example, if the parties to the contract agree that the base rate for the total returns is to be LIBOR + X bps, the protection buyer is agreeing to swap with the protection seller the actual returns from a generic reference asset or assets –e.g. a corporate bond, or index of corporate bonds– in return for LIBOR + X bps. But if, for instance, there is any depreciation in the market value of the referent at some point during the tenure of the swap, the protection seller will transfer to the protection buyer the new difference between its actual returns and the total returns of the base rate spread. Likewise, in the event of any appreciation in value of the generic asset, the protection buyer will increase the payment of actual returns to the protection seller to reflect this change as well.

For this reason, sometimes the protection buyer is more precisely called the ‘total return payer’, and the protection seller ‘the total return receiver’, since the intention of the parties to the exchange is not so much the buying and selling of protection on a credit event, but the swapping of total valuation risks and cash flows attached to the respective referent. The object of this exchange is therefore called a ‘total return swap’ because the parties to the exchange are swapping the total risks determinate of the cash flow return on some generic financial asset or index of assets. And as with any credit derivative, the exchange is said to be ‘synthetic’ insofar as the exchange is synthetically replicating certain specified economic properties from its referent –in the case of a TRS, these properties are the total risks and cash flow, reflected as the total returns and ongoing market value of the generic financial asset or assets.

ii. Brief comparison of the ontologies of a single-name CDS and a single-name TRS will yield more insight.

First, in a TRS, the parties swap cash flows on an ongoing basis, and constantly adjust the amount to reflect any change in returns or market valuation of the referent; whereas in a CDS the payoff for the buyer is contingent upon the occurrence of a credit event. While in both cases there is nothing to prevent the occurrence of credit event resulting in either cash or physical settlement and subsequent termination of the swap, it is worth observing that an adjustment in cash flow in the single-name CDS transaction is contingent upon a one-time credit event, while the TRS could be perpetually revalued an ongoing basis, but written to include credit events as well. In this respect, the TRS already points towards the development of a structured synthetic financial asset –such as a synthetic CDO– whose cash flow is interminable, perpetually adjusted on an ongoing basis, and wherein the cash flow actually is the asset, as such. We will later indulge the question of what would be the concrete effects of universally-distributing such a class of instruments.

Secondly, while a single-name CDS replicates exposure to an individual and specific reference obligation from a generic financial exchange, and notably does so through the act of exchanging a specific kind of risk –the risk of default, ratings downgrade, or some like-credit event; by contrast a single-name TRS replicates exposure to the total risks of an asset –including its default risk, interest rate risk, currency risk, etc.– and in this respect is a more comprehensive replication of the risks attaching to the generic referent. In fact, if the CDS’ definitions of a credit event were broadened so as to include any incremental change in cash flow or ongoing mark-to-market valuation of its referent, and if the requirement to terminate the swap with occurrence of a credit event was simply dropped from the terms of the exchange (i.e. so that the swapped cash flow was perpetual and interminable), all other superficial ontological differences between a CDS and TRS would collapse. This is obviously not the case. But it does give us some insight into the progressive fungibility of synthetic financial objects which are otherwise lacking in either physical economic objects or in generic financial objects. And again, although we colloquially speak here of synthetic ‘objects’, let us observe that –as with a CDS, so too with a TRS– it is the process of the exchange itself which constitutes the asset, rather than the exchange constituting the process by which some preexisting assets are exchanged.

And so finally, let us once more observe that in both instances of synthetic financial exchange thus far considered, the physical property ostensibly tied to the generic referent remains unaffected and otherwise untransformed; ownership of any physical assets remains totally unchanged, and so on. And yet in a synthetic exchange, the important economic properties of risk and cash flow are capable of being created ex nihilo, and plastically redirected or otherwise distributed. This plastic distributive potential of credit derivatives is a topic for further investigation by speculative materialism.

Thanks to Natalie Brescia
Thanks to Natalie Brescia

[1] LIBOR (or London Interbank Offered Rate) is a globally-used primary benchmark for interest rates.

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