What is an 'Asset Swap'

An asset swap is similar in structure to a plain vanilla swap with the key difference being the underlying of the swap contract. Rather than regular fixed and floating loan interest rates being swapped, fixed and floating assets are being exchanged.

All swaps are derivative contracts through which two parties exchange financial instruments. These instruments can be almost anything, but most swaps involve cash flows based on a notional principal amount agreed upon by both parties. As the name suggests, asset swaps involve an actual asset exchange instead of just cash flows.

Swaps do not trade on exchanges, and retail investors do not generally engage in swaps. Rather, swaps are over-the-counter contracts between businesses or financial institutions.

BREAKING DOWN 'Asset Swap'

Asset swaps can be used to transform the cash flow characteristics of the underlying asset in order to hedge currency, credit and/or interest rate risks, or creating a synthetic investment with more suitable cash flow characteristics. Typically, an asset swap involves transactions in which the investor acquires a bond position and then enters into an interest rate swap with the bank that sold him/her the bond. The investor pays fixed and receives floating. This transforms the fixed coupon of the bond into a LIBOR-based floating coupon.

It is widely used by banks to convert their long-term fixed rate assets to a floating rate in order to match their short-term liabilities (depositor accounts).

Another use is to insure against loss due to credit risk, such as default or bankruptcy, of the bond's issuer. Here, the swap buyer is also buying protection.

How an Asset Swap Works

Whether the swap is to hedge interest rate risk or default risk, there are two separate trades that occur.

First, the swap buyer purchases a bond from the swap seller in return for a full price of par plus accrued interest (called the dirty price).

Next, the two parties create a contract where the buyer agrees to pay fixed coupons to the swap seller equal to the fixed rate coupons received from the bond. In return, the swap buyer receives variable rate payments of LIBOR plus (or minus) an agreed upon fixed spread. The maturity of this swap is the same as the maturity of the asset.

The mechanics are the same for the swap buyer wishing to hedge default or some other event risk. Here, the swap buyer is essentially buying protection and the swap seller is also selling that protection.

As before, the swap seller (protection seller) will agree to pay the swap buyer (protection buyer) LIBOR plus (or minus) a spread in return for the cash flows of the risky bond (the bond itself does not change hands). In the event of default, the swap buyer will continue to receive LIBOR plus (or minus) the spread from the swap seller. In this way, the swap buyer has transformed its original risk profile by changing both its interest rate and credit risk exposure.

RELATED TERMS
  1. Swap Curve

    A swap curve identifies the relationship between swap rates at ...
  2. Floating Price

    The floating price is a leg of a swap contract that depends on ...
  3. Accreting Principal Swap

    An accreting principal swap is a derivative contract that features ...
  4. Reverse Swap

    A reverse swap is an exchange of cash flow streams that undoes ...
  5. Inflation Swap

    An inflation swap is a transaction in which two parties exchange ...
  6. Foreign Currency Swap

    A foreign currency swap is an agreement to exchange currency ...
Related Articles
  1. Trading

    An Introduction To Swaps

    Learn how these derivatives work and how companies can benefit from them.
  2. Trading

    What Warren Buffet Calls "Weapons of Mass Destruction": Understanding the Swap Industry

    A full analysis of how the swap industry works.
  3. Trading

    How To Value Interest Rate Swaps

    An interest rate swap is a contractual agreement between two parties agreeing to exchange cash flows of an underlying asset for a fixed period of time.
  4. Trading

    Different Types of Swaps

    Identify and explore the most common types of swap contracts. Swaps are derivative instruments that represent an agreement between two parties to exchange a series of cash flows over a specific ...
  5. Trading

    Currency Swap Basics

    Find out what makes currency swaps unique and slightly more complicated than other types of swaps.
  6. Investing

    How To Read Interest Rate Swap Quotes

    Puzzled by interest rate swap quotes terminology? Investopedia explains how to read the interest rate swap quotes
  7. Investing

    The Advantages Of Bond Swapping

    This technique can add diversity to your portfolio and lower your taxes. Find out how.
  8. Investing

    CFTC Probes Banks' Use of Interest Rate Swaps

    U.S. regulators are probing banks' trading and clearing of interest rate swaps, which played a central role in the 2008 financial crisis
  9. Investing

    The Fast-Paced World of Libor & Fixed Income Arbitrage

    LIBOR is an essential part of implementing the swap spread arbitrage strategy for fixed income arbitrage. Here is a step-by-step explanation of how it works.
  10. Investing

    PIMCO’s Mutual Fund for Investment Grade Bonds (PTTRX)

    Explore the complicated and often arcane makeup of the PIMCO Total Return Fund, and identify the fund's management style and top five holdings.
RELATED FAQS
  1. How do companies benefit from interest rate and currency swaps?

    Interest rate and currency swaps help companies manage exposure to rate fluctuations and acquire a lower rate than they would ... Read Answer >>
  2. How do currency swaps work?

    Learn how a currency swap works, including who uses these transactions, and the mechanics and purpose of the different cash ... Read Answer >>
  3. What is a Debt for Equity Swap?

    Learn why companies issue debt for equity swaps, what they are, and how they impact shareholders and debt holders. Read Answer >>
  4. How do companies benefit from interest rate swaps?

    Learn how companies can swap interest rate payments and mutually benefit. Find out how these swaps arbitrage differences ... Read Answer >>
  5. Interest Rate Risk Between Long-Term and Short-Term Bonds

    Find out the differences and effects of Interest rates between Long-term and short-term bonds. Read how interest rate risk ... Read Answer >>
Trading Center