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Total-Return Swaps look like shares and pay like shares. But why aren’t they shares?

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Banks have begun encouraging large investors to buy total-return swaps instead of shares. Total-return swaps are securities that offer the same income and capital gains as the underlying shares.

If the payoff is the same to the investor, then what is the reason behind the need for a derivative? New regulation has been put in place requiring banks to set aside additional capital to facilitate certain trades of shares, this capital requirement is avoided through the use of these total-return swaps.

Banks are going so far as to advertise to their clients when a total-return sway would be more cost effective to the investor in an attempt to usher the investor away from the share and towards the derivative.

The downside for the investor is that these swaps become illiquid because of the difficulty pricing this new derivative.

The practice of replacing shares with swaps is already common practice in Asia, where the derivatives are used to gain exposure to shares that are otherwise inaccessible.

The premise that this derivative was created with the intention of side-stepping legislation (which one hopes is put in place to protect investors) could make investors suspicious of the new product. Furthermore, should the investor encourage this behaviour from the banks by supporting their rule-avoiding?

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