Pricing Total Return Swaps

Abstract

Total return swap (TRS) involves a pricing dilemma: LIBOR discounting of its premium leg forces upfront payment of future funding premium, and yet replacing LIBOR with a firm’s own funding rate falls into the well-known FVA debate trap. We consider TRS hedge financing from a repo market perspective and apply postcrisis derivatives valuation with collateralization and funding to TRS. We find that the financing cost of the TRS hedge should be reflected on the security leg, and the funding premium can only be discounted in conjunction with the TRS as a whole, depending on margining schemes. An easy to implement, recursive tree model is developed to value TRS with repo-style margining or defaultable underlying, together with any value adjustments.