In a total return swap, what does one party agree to pay?

In a total return swap, one party agrees to pay the total return on a specified security, which includes both the anticipated cash flows (such as dividends or interest payments) and any capital appreciation or depreciation occurring over the life of the swap. This means that the party receiving the total return benefits from any increases in the value of the security as well as any periodic income it generates.

The total return swap allows one party to gain exposure to the performance of an underlying asset without actually owning it, while the other party receives a stream of fixed or floating payments, often tied to a benchmark interest rate or other reference rates. This structure can be advantageous for parties looking to hedge risk or gain leveraged exposure to specific securities.

Understanding this mechanism clarifies the nature of the swap and highlights its primary purpose, which is to transfer the economic performance of the underlying asset rather than simply interest payments or principal repayments associated with traditional bonds or loans. This dynamic sets total return swaps apart from more conventional financial instruments.