TRS Break Rights, Contract Terms, and the Cost of Hedging
Summary
A total return swap is an over-the-counter contract, so whether it can be terminated early depends on the negotiated termsheet. Some agreements provide break rights and others lock the parties in until maturity. The responses describe dealer-to-dealer trades as often locked and customer-to-dealer trades as often breakable, while emphasizing that these are tendencies rather than universal rules.
Break rights can affect a dealer's hedge and the swap's price. The example compares buying the underlying shares, which requires substantial funding, with using futures, which generally requires margin and may reduce funding costs. If the swap can be broken and its unwind value is based on spot rather than the forward price, changes in the spot-futures basis can make a futures hedge lose money on termination. Holding the shares may better match that exposure, but its funding cost can raise the swap fee. The example is illustrative; actual break terms, unwind valuation, hedging choices, and pricing depend on the contract and counterparties.
Key ideas
- A TRS may be breakable or locked in depending on the counterparties' negotiated terms.
- Break rights and unwind valuation affect which hedge best matches the swap exposure.
- A futures hedge can create basis risk when a breakable swap is unwound at spot value.
- Buying the underlying shares can better match that breakable exposure but requires more funding.
- The example describes a pricing trade-off, not a universal market rule.
Tags
Full text
# Is Breakable TRS subject to an option in the termsheet? # Is Breakable TRS subject to an option in the termsheet? Does sombody know exactly if a TRS is always breakable ? Or if breaking the TRS position is an option in the term-sheet. I need an accurate response. Thank you ! ## Answer by JoshK (score 2) https://quant.stackexchange.com/a/69098 A TRS is an OTC trade so the terms are negotiable. Some TRS's are breakable and some are not. Some TRS trades are locked in with multi-year terms and some are daily breakable. It really depends on what the counterparties want to do. As a general rule you will find that dealer-to-dealer trades are locked and customer-to-dealer trades are fully breakable. But that's not always the case. ## Answer by will (score 1) https://quant.stackexchange.com/a/65536 The reason that break rights are important is because they influence how the trade can be hedged. Let's say, for example, that i sell you a swap on $100m of apple, expiring in a year. I have a few ways i can choose to hedge this - - I can buy \$100m of apple shares and hold them to expiry - I can buy \$100m of apple futures to some date near to the expiry of the swap - I can ask my brokers if anyone wants to trade a forward on apple with me, otc. We'll ignore option 3, as it's basically just passing the risk off to someone else, and doesn't really provide any insight here. For option 1, we can to consider that it's going to cost me \$100m to buy all those shares, which means i need to borrow $100m from somewhere to do so (where that cost of funding the position will get included in the swap fee i charge you). In option 2, i don't need to fund the futures position, i only need to pay margin, let's say 20%, so i need to borrow less money, which means lower costs - so i can show you a much cheaper swap fee (i.e. i can be more competitive with otherse you ask for a swap rate). If we now add in a clause where the swap is breakable at any time, and if it's broken, then the payout is current price - strike price (instead of forward price - strike price), then if i hedge using futures and the spot/futures basis moves against me, then i can potentially lose money on the unwind - i.e. it is not a good hedge. Because of this, the correct way to hehdge the breakable variant is to buy the actual stocks, so the breakable swap should have a higher cost, since the funding costs are higher. ## Answer by JoshK (score 0) https://quant.stackexchange.com/a/61257 TRS are OTC. You can set any terms that both parties accept. That includes rate, tenor, break rights. Etc etc etc
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