Suppose two parties enter into a one-year total return swap, in which one party receives the London Interbank Offered Rate (LIBOR) in addition to a fixed margin of 2%. The other party obtains the total return of the Standard and Poor`s 500 Index (S-P 500) on a capital amount of $1 million. The overall beneficiary of the return, the investor, is not the rightful owner of the reference asset, nor is the tenant the rightful owner of the car. The TRS is an off-balance sheet transaction and the reference asset value does not appear on the recipient`s balance sheet. For the period of the transaction only, the total beneficiary of the product has a long synthetic position in market risk and a long synthetic position in the credit risk („prejudice“) of the reference asset. At the end of the transaction, the total return recipient may acquire the benchmark at the prevailing market price, but is not required. In the event of a default of the benchmark asset before the SRR due date, the TRS usually ends, but does not necessarily have to be terminated. We will look at the case where this does not end later, because in most cases of failure, the TRS is terminated. The overall return of the beneficiary is, in both cases, the responsibility of risk in the event of a default. When the SRR ends due to a default, the overall beneficiary of the return, the investor, makes the overall return of the repayment „whole“ for market risk and credit risk of the benchmark asset. The investor can make a net payment of the difference between the price of the reference guarantee at the beginning of the transaction and the price of the reference guarantee at the time of default. In addition, the investor may agree to take over the provision of the late reference asset and pay the initial price of the reference asset at the taxpayer`s overall interest rate.
Once this has been done, neither the payer nor the recipient has an additional commitment to the other party, and the TRS is granted. The other great advantage of a total return swap is that it allows the TRS beneficiary to make a loan-financed investment and thus make the most of its investment capital. Unlike a repurchase agreement that transfers ownership of assets, no ownership transfer is made in a TRS contract. This means that the recipient of the overall return is not required to register substantial capital to acquire the asset.