Total Return Swap

Also referred to as Total Rate of Return Swap, <TRORS, Cash Settled Equity Swap
This type of contract transfers credit risk and market risk
Not a pure credit derivative because it transfers both credit and market value risk.


What is the benefit ?

Allows a party to get exposure to an asset without actually putting that asset on its balance sheet.
Hedge funds use TRS to obtain leverage on the underlying asset.
They can receive the return of an asset without having to buy the asset in full.
They can post a smaller amount of collateral upfront therefore obtaining leverage.


Always has 2 legs
a security leg and a financing leg


Fully Funded ?





Example

Lets say I want $10m exposure to Nestle by I only have $1m
Therfore looking for massive leverage
Find someone (or a bank) that has $10m exposure to Nestle and arrange a TRS with them
I would get the necessary exposure in exchange to a monthly fee.
Exposure being any P&L movement + dividend
In this scenario I don't own the asset so it is not on my balance sheet (therefore no liability)



Haircut

When used in the context of exchange traded products such as stocks, options or futures, haircut is used interchangeably with the term margin
It is the amount of capital required by a broker to maintain the positions currently in a trading account.
If haircut exceeds the account's capital, the broker can either require additional capital (e.g. margin call), or liquidate positions until the haircut no longer exceeds available capital.
Haircuts are given in basis points.


In finance, a haircut is a percentage that is subtracted from the par value of the assets that are being used as collateral. The size of the haircut reflects the perceived risk associated with holding the assets.


For example, Treasury bills (which are seen as fairly safe) might have a haircut of 1%, while for a stock option (which are seen as less safe) the haircut might be as high as 30%.




This is related to a difference in credit ratings


Company A has rating AAA
Company B has rating AA


If company A buys a bond from company B then company A might want a haircut of 5% for the additional risk of Company B defaulting




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