Learning Curve Richard Pereira September 2003
2 Asset swaps Asset swaps combine an interest-rate swap with a bond and are seen as both cash market instruments and also as credit derivatives. They are used to alter the cash flow profile of a bond. The asset swap market is an important segment of the credit derivatives market since it explicitly sets out the price of credit as a spread over Libor. Pricing a bond by reference to Libor is commonly used and the spread over Libor is a measure of credit risk in the cash flow of the underlying bond. Asset swaps can be used to transform the cash flow characteristics of reference assets, so that investors can hedge the currency, credit and interest rate risks to create synthetic investments with more suitable cash flow characteristics. An asset swap package involves transactions in which the investor acquires a bond position and then enters into an interest rate swap with the bank that sold him the bond. The investor pays fixed and receives floating. This transforms the fixed coupon of the bond into a Libor based floating coupon. As an example, consider an entity that wishes to insure against loss to due to credit events such as default or bankruptcy of the issuer of a bond it is holding. As a protection buyer holding this risky bond, it wishes to hedge the credit risk of this position. By means of an asset swap the protection seller will agree to pay the protection buyer Libor +/- a spread in return for the cash flows of the risky bond (there is no exchange of notional at any point). In the event of default the protection buyer will continue to receive the Libor +/- a spread from the protection seller. In this way the protection buyer has transformed its original risk profile by changing both its interest rate and credit risk exposure. The generic structure of an asset swap is shown at Figure 1.
LIBOR +/- Spread
Coupons on bond