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 (OTC) contracts between businesses or financial institutions.
- An asset swap is used to transform cash flow characteristics to hedge risks from one financial instrument with undesirable cash flow characteristics into another with favorable cash flow.
- There are two parties in an asset swap transaction: a protection seller, which receives cash flows from the bond, and a swap buyer, which hedges risk associated with the bond by selling it to a protection seller.
- The seller pays an asset swap spread, which is equal to the overnight rate plus (or minus) a pre-calculated spread.
Understanding an Asset Swap
Asset swaps can be used to overlay the fixed interest rates of bond coupons with floating rates. In that sense, they are used to transform cash flow characteristics of underlying assets and transforming them to hedge the asset's risks, whether related to currency, credit, and/or interest rates.
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 them 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.
The Process of an Asset Swap
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.
Due to recent scandals and questions around its validity as a benchmark rate, LIBOR is being phased out. According to the Federal Reserve and regulators in the U.K., LIBOR will be phased out by June 30, 2023, and will be replaced by the Secured Overnight Financing Rate (SOFR). As part of this phase-out, LIBOR one-week and two-month USD LIBOR rates will no longer be published after Dec. 31, 2021.
How Is the Spread of an Asset Swap Calculated?
There are two components used in calculating the spread for an asset swap. The first one is the value of coupons of underlying assets minus par swap rates. The second component is a comparison between bond prices and par values to determine the price that the investor has to pay over the lifetime of the swap. The difference between these two components is the asset swap spread paid by the protection seller to the swap buyer.
Example of an Asset Swap
Suppose an investor buys a bond at a dirty price of 110% and wants to hedge the risk of a default by the bond issuer. She contacts a bank for an asset swap. The bond's fixed coupons are 6% of par value. The swap rate is 5%. Assume that the investor has to pay 0.5% price premium during the swap's lifetime. Then the asset swap spread is 0.5% (6 - 5 - 0.5). Hence the bank pays the investor LIBOR rates plus 0.5% during the swap's lifetime.
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