An asset swap is similar in structure to a plain vanilla swap with the key difference being the underlying components of the swap contract. Instead of simply swapping regular fixed and floating loan interest rates, fixed and floating assets are 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 rather than just cash flows.
Swaps trade over-the-counter (OTC) between businesses or financial institutions and are not typically engaged in by retail investors.
Key Takeaways
- An asset swap is used to transform cash flow characteristics, hedging against risks from one financial instrument with undesirable cash flow traits into another with favorable traits.
- There are two parties in an asset swap transaction: a protection seller, who receives cash flows from the bond, and a swap buyer, who hedges risk associated with the bond by selling it to a protection seller.
- The seller pays an asset swap spread, which equals the overnight rate plus (or minus) a pre-calculated spread.
Understanding an Asset Swap
Asset swaps can overlay the fixed interest rates of bond coupons with floating rates, transforming cash flow characteristics and mitigating risks related to currency, credit, or interest rates.
Typically, an asset swap involves an investor acquiring a bond position and then entering into an interest rate swap with the bank that sold the bond. The investor pays fixed and receives floating, converting the fixed coupon of the bond into a LIBOR-based floating coupon.
Banks often use asset swaps to convert their long-term fixed rate assets to a floating rate to match their short-term liabilities, such as depositor accounts.
Asset swaps are also used to hedge against credit risk, such as the risk of default or bankruptcy of the bond’s issuer. Some complex asset swaps, like asset-swapped convertible option transactions (ASCOT), separate fixed-income and equity components of a bond offering.
The Process of an Asset Swap
Whether hedging interest rate risk or default risk, two separate trades occur in an asset swap.
First, the swap buyer purchases a bond from the swap seller at the dirty price (par plus accrued interest). Next, the two parties create a contract where the buyer pays fixed coupons to the swap seller (equal to the bond’s fixed-rate coupons) and, in return, receives variable rate payments of LIBOR plus (or minus) an agreed-upon spread. The maturity of the swap matches the maturity of the asset.
For hedging default or other event risks, the swap buyer essentially buys protection, and the swap seller sells that protection. The swap seller agrees to pay the swap buyer LIBOR plus (or minus) a spread in return for the cash flows from the risky bond. In case of default, the swap buyer continues to receive LIBOR plus (or minus) the spread from the swap seller, transforming its risk profile.
Due to recent scandals and questions about its validity as a benchmark rate, LIBOR is being phased out by June 30, 2023, and replaced by the Secured Overnight Financing Rate (SOFR).
Calculation of the Asset Swap Spread
There are two components used in calculating the spread for an asset swap:
- The value of coupons of underlying assets minus par swap rates.
- A comparison between bond prices and par values to judge the price paid over the swap’s lifetime.
The difference between these 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 against the risk of a default by the bond issuer. They contact a bank for an asset swap. The bond’s fixed coupons are 6% of par value, and the swap rate is 5%. Assuming the investor must pay a 0.5% price premium during the swap’s lifetime, the asset swap spread would be 0.5% (6 - 5 - 0.5). Hence, the bank pays the investor LIBOR rates plus 0.5% over the swap’s lifetime.
Related Terms: Plain Vanilla Swap, Interest Rate Swap, Credit Risk, LIBOR, SOFR, Maturity, Over-the-Counter.
References
- The Intercontinental Exchange. “LIBOR”.
