There are different types of risks to which the parties are exposed in a TRS contract. One of them is counterparty risk. When a hedge fund issues multiple TRS contracts on similar core assets, any loss in value of those assets results in lower returns, given that the fund continues to make regular payments to the payer/owner of TRS. If the depreciation of assets continues over a long period of time and the hedge fund is not sufficiently capitalized, the payer risks losing the fund. The risk can be increased by the high level of confidentiality of hedge funds and the treatment of these assets as off-balance-sheet items. Less prevalent, but related, are participatory return swap agreements and reverse rights exchange agreements, which typically include 50% of the return or another specific amount. Reverse swaps include selling the asset with the seller and then buying the returns, usually on stocks. Hedge funds use full return swaps to gain leverage on benchmark assets: they can get the return on the asset, typically from a bank (which has a funding cost advantage) without having to spend the money to buy the asset. They usually post a smaller amount of collateral in advance and thus gain leverage. Another type of OEE is one for which the underlying asset is that of a stock, index or basket of shares. They are generally structured in such a way as to reference either the overall return (price changes, dividends, commissions, etc.) or only price changes. After a year, when LIBOR is 3.5% and the S&P 500 recovers by 15%, the first part of the second part pays 15% and gets 5.5%. The payment is cleared at the end of the swap, with the second party receiving a payment of $95,000 or [$1 million x (15% – 5.5%).).
Hedge funds (such as the Children`s Investment Fund (TCI) have attempted to use full return swaps to circumvent disclosure obligations imposed under the Williams Act. As in CSX Corp. v. Children`s Investment Fund Management, TCI, argued that it was not the beneficial owner of the shares to which its full return swaps relate and that, therefore, the swaps did not require TCI to publicly disclose that it had acquired a more than 5% interest in CSX. The U.S. District Court rejected this argument and rejected any further violations of Section 13(d) Securities Exchange Act and the SEC rule set forth therein.  An alternative fund counterparty appears to be a perversion of the concept of credit derivatives. Do I consider the hedge fund as a single A? Most banks would explicitly say no. Do I consider the hedge fund to be BB+? The problem is that no one really knows. Hedge funds do not disclose sufficient information to make this assessment. The fact that banks are willing to do this business with hedge funds shows how difficult it is for banks to earn income from their traditional investment-level credit activities.
Investment-level loans have an overall low return on investment. The primary objective of the banks is not an increase in distribution. The main objective is to account for higher spread returns. The question remains whether the increase in spreads, which hedge funds are willing to pay as refinancing fees, are sufficient to compensate banks for credit risk. Among the major players in the total return swap market are large institutional investors such as investment banks, investment funds, commercial banks, pension funds, funds of funds of funds (FOF) A fund of funds (FOF) is an investment vehicle in which a fund invests in a portfolio composed of units of other funds. private equity funds, insurance companies, NGOs and governments. . . .