Asset Swaps

An asset swap is a structure which allows an investor to swap fixed rate payments on a bond to
floating rate while maintaining the original credit exposure to the fixed rate bond.
o The investor retains credit risk to the fixed-rate bond, earning a corresponding return.
Par asset swap
o On initiation, the asset swap buyer buys a bond from the asset swap seller in return for
full par price (100).

Time 0

Asset Swap Seller

CF0 = 100
Value of position = 100 - P - SW

Asset Swap Buyer

CF0 = -100
Value of position = -100 + P + SW

Where SW is the value of the swap at initiation of the trade; SW =

100 - P so that the asset swap seller and buyer both start with a
position worth 0.
o

The asset swap buyer enters into a swap to pay fixed coupons (equal to the coupons on
the bond). The asset swap seller pays Libor + a fixed spread. The maturity of the swap is
the same as the bond.

Time t < T1
Time T
o

Asset Swap Seller

CFt = -(Libor + S) + C
CFT = -(Libor + S) + C

Asset Swap Buyer

CFt = C - C + Libor + S = Libor + S
CFT = Libor + S + 100

Upon default, the asset swap buyer loses bond coupons and principal redemption on
the bond. The swap will continue until bond maturity or can be closed out at market
value.

Realistically, the frequency of payments on the fixed and floating legs can be different.

Asset Swap Seller

Asset Swap Buyer
If not closed out immediately:
Time t < T
CFt = -(Libor + S) + C
CFt = -C + Libor + S + 100*R
Time T
CFT = -(Libor + S) + C
CFT = -C + Libor + S
If closed out at market value upon default, the asset swap buyer will receive the recovery value of the
bond. A final exchange will be made between the buyer and seller based on the value of the swap.
o

The asset swap spread is the fixed spread to Libor paid by the asset swap seller. It is set
at the inception of the swap such that the net value of the sale of the bond plus the
swap transaction is 0.

Where:
C is the coupon on the bond
N(Fix) and N(Flt) are the number of fixed and floating payments,
respectively, during the life of the swap (the payment frequency of the
fixed and floating legs could be different)
zi is the discount factor
i is the accrual factor
Li is the Libor rate set at ti-1 and paid at ti
S is the asset swap spread
The buyer of the asset swap takes on the credit risk of the bond, in terms of coupon loss
and risk of default. If the bond defaults, the buyer must continue to pay the fixed leg of
the swap without funding from the bonds coupons, and also loses the par value of the
bond at maturity, instead taking whatever recovery value the bond has to offer.
The asset swap spread is used to compensate the asset swap buyer for taking on
these risks.
Asset swap on a discount bond vs premium bond: investors can lose more than they
paid if a premium bond defaults immediately following the initiation of the asset swap.
For example, at inception, Bond = 120, Swap = -20, Total Value = 100
Bond defaults immediately after. Bond (recovery value) = 10, Swap = -20, Total
Value = -10.
So the investor has lost -110 = 10 - 120 while only investing 100. This is due to
the leveraged nature of the transaction.

The maximum the par asset swap buyer can make is (100-Recovery). In this sense, an
asset swap spread is similar to a default swap spread since credit default swaps also pay
out (100-Recovery) upon default.
Market asset swap
o At initiation, the bond is exchanged for its market price.

Time 0

Asset Swap Seller

CF0 = P
Value of position = P - SW

Asset Swap Buyer

CF0 = -P
Value of position = -P + SW

Where SW, value of the swap on the floating side, is equal to the
full market price of the bond.
o

The asset swap buyer pays fixed coupons (equal to the coupons on the bond). The asset
swap seller pays (Libor + a fixed spread) on a notional of P (rather than par value of 100
as in a par asset swap).

Time t < T

Asset Swap Seller

CFt = -(Libor + S)
+C

Asset Swap Buyer

CFt = C - C + (Libor + S)

(Libor + S)

At maturity, there is an exchange of par for the original bond price. The buyer will also
receive full par value of the bond.

Time T

Asset Swap Seller

CFT = 100 - P

Asset Swap Buyer

CFT = -100 + P + 100 = P

The market asset swap spread (M) is calculated as:

Using the same notation as in the par asset swap example, we find that

Differences between par asset swap and market asset swap:

Par asset swap

Bond is purchased at par.
Counterparty exposure for premium bonds
is taken by the asset swap seller.

Counterparty exposure is greatest at

initiation and falls to 0 at maturity.
No exchange at maturity.

Market asset swap

Bond is purchased at market price.
For premium bonds, counterparty
exposure is assumed by asset swap buyer.
For discount bonds, counterparty
exposure is assumed by asset swap seller.
Counterparty exposure starts at 0 and
increases to maximum at maturity.
At maturity, there is an exchange of par
for the original price of the bond.

Variations on asset swaps:

o Forward asset swaps can be used to long a credit at some future date at a known price.
The investor agrees to buy the bond on the forward date at par and enter into
an interest rate swap where the asset swap spread is agreed to today.
The investor doesnt take default risk until the forward date so if the bond
defaults before the forward date, the trade terminates.
o Cross-currency asset swaps enable investors to buy a bond denominated in one
currency, pay on the swap in this currency, and receive floating in the base currency.
The cash flows are converted at a predefined exchange rate.
There is an exchange of principal at the end of the swap.
Investors using this type of asset swap can gain credit exposure while reducing
interest rate and FX risk.
o Callable asset swaps are asset swaps using callable bonds as the fixed rate security.
A callable asset swap buyer who wishes to be hedged against losses on the swap
in the event the bond is called back. This can be done by buying a Bermudanstyle receiver swaption. This structure is called a cancellable asset swap.
Callable asset swaps can also strip out credit and equity components of
convertible bonds.

Measuring credit risk using asset swap spreads

Because the asset swap spread also depends on the price of the bond, it cannot be
readily used for comparing the markets view of credit quality across different bonds
and issuers.
A better measure is the zero volatility spread, which is the continuously compounded
spread to the Libor curve required to reprice a bond. It is calculated by solving the
below:

The CDS-cash basis is equal to the CDS premium less the par asset swap spread. If the CDS-cash
basis is negative, then an investor can buy protection in the CDS contract and buy the asset
swap and vice versa if the CDS-cash basis is positive.
o A non-zero CDS-cash basis can be attributable to more fundamental factors than simply
supply/demand dislocations. These factors include:
Liquidity risk differentials
Funding risk for asset swaps
Accrued premiums in CDS contracts
Counterparty credit risk
Default-contingent exposure in asset swaps
CTD features of CDS contracts