Relating Total Return Swap Financing to Borrow Costs and Futures

# Total Return Swaps and Borrow Cost Relationship


# Total Return Swaps and Borrow Cost Relationship












> If an investor is long a Total Return Swap (TRS), they get the total return (ie, including dividend) performance and usually pay LIBOR minus a spread. This spread should trade inline with borrow costs (and implied repo of a forward if the risk free rate/funding is considered to be LIBOR and the effect of taxation is ignored).

Why should this spread trade inline with borrow costs? This is totally not clear at all.

[Source for the above quote is the following document on dividend trading from Barclays Capital (page 41) link. The "borrow costs" referred to are "borrow costs fr shares underlying an index".]

## Answer by AlRacoon (score 4, accepted)

https://quant.stackexchange.com/a/38438

These total return swaps are basically funding trades.

The seller of total return is putting the risk on their balance sheet. In order to pay the total return to the buyer of total return, the seller would need to hedge their risk by buying the risk of the asset.

If effect, the total return seller is lending the total return buyer the funds to gain the risk and therefore will earn the lending rate.

These are very similar to futures. If you understand SPX index futures, you should be able to understand Total Return Swaps. Total Return Swaps are basically over the counter analogs of futures.

Edit: To clarify how TRS and futures are similar.

Future:

Trade Inception:

You pay nothing upfront (except margin, which is basically surety that you will make payment if this turns out to be a losing trade.

Pricing of futures:

$$S * e^{(r-d)t} = F$$

Where:

S = Current price of the Reference Index

r = funding rate

d = dividend yield

t = time to maturity of the future

F = Future price of the Reference Index (fair price)

Note: While I show the funding rate as a continuously compounded rate, in reality it is usually calculated by the dealers as $$1 + \text{LIBOR}\, (\text{Act}\,/360) \,– \text{Div Yld} * t$$

At maturity of the Future:

You will receive any gain on the Reference Index above the agreed upon Future price or pay any loss on the Reference Index below the agreed upon Future price.

Total Return Swap:

Trade Inception:

You also pay nothing upfront (except the margin your broker/dealer will charge you to enter into the trade—depending on your creditworthiness).

At maturity of the Swap:

You will receive any gain on the Reference Index above the Spot price of the Reference Index or pay any loss on the Reference Index below the Spot price. You will have received any dividends as part of your Total Return.

You will also pay to the seller of the Total Return Swap:

$$S * (\text{LIBOR} \,+/- \,\text{spread})(\text{Act}/360)$$

The spread will be determined by market conditions which will reflect whether the dealer can lend/borrow the securities, the dealers cost of funding, the regulatory capital etc. In the futures markets, these same factors are accounted for by whether the futures are trading rich or cheap to the fair price of the future calculated above.

It is easy to see that the only difference between the Future and the Total Return Swap is that the Future Price bakes into it the financing from which to assess your gain or loss at maturity, while the Total Return Swap explicitly charges the financing rate at the maturity of the swap. The financing rate is agreed upon at the inception of the TRS, just as the financing rate is determined on trade date of the Future.