What Is an Asset Swap?
An asset swap is alike resemble in structure to a plain vanilla swap with the key difference being the underlying of the swap contract. Rather than likeable fixed and floating loan interest rates being swapped, fixed and floating assets are being exchanged.
All swaps are borrowed contracts through which two parties exchange financial instruments. These instruments can be almost anything, but most swaps entangle cash flows based on a notional principal amount agreed upon by both parties. As the name suggests, asset swaps catch up in an actual asset exchange instead of just cash flows.
Swaps do not trade on exchanges, and retail investors do not conventionally engage in swaps. Rather, swaps are over-the-counter contracts between businesses or financial institutions.
- An asset swap is occupied to transform cash flow characteristics to hedge risks from one financial instrument with undesirable cash whirl characteristics into another with favorable cash flow.
- There are two parties in an asset swap transaction: a bulwark seller, which receives cash flows from the bond, and a swap buyer, which hedges risk associated with the manacles by selling it to a protection seller.
- The buyer pays an asset swap spread, which is equal to LIBOR plus (or minus) a pre-calculated spread.
Basics of an Asset Swap
Asset swaps can be Euphemistic pre-owned to overlay the fixed interest rates of bond coupons with floating rates. In that sense, they are worn to transform cash flow characteristics of underlying assets and transforming them to hedge the asset’s risks, whether coupled to currency, credit, and/or interest rates.
Typically, an asset swap involves transactions in which the investor acquires a hold together position and then enters into an interest rate swap with the bank that sold them the handcuffs. The investor pays fixed and receives floating. This transforms the fixed coupon of the bond into a LIBOR-based carry off coupon.
It is widely used by banks to convert their long-term fixed rate assets to a floating rate in sisterhood to match their short-term liabilities (depositor accounts).
Another use is to insure against loss due to credit risk, such as non-payment 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 attract rate risk or default risk, there are two separate trades that occur.
First, the swap buyer purchasings a bond from the swap seller in return for a full price of par plus accrued interest (called the dirty payment).
Next, the two parties create a contract where the buyer agrees to pay fixed coupons to the swap seller equal to the definite rate coupons received from the bond. In return, the swap buyer receives variable rate payments of LIBOR bonus (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 client wishing to hedge default or some other event risk. Here, the swap buyer is essentially buying safe keeping and the swap seller is also selling that protection.
As before, the swap seller (protection seller) will accede to to pay the swap buyer (protection buyer) LIBOR plus (or minus) a spread in return for the
Due to recent scandals and questions in all directions from 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 side out by June 30, 2023, and will be replaced by the
How Is the Spread of an Asset Swap Calculated?
There are two components used in calculating the spread for an asset swap. The chief one is the value of coupons of underlying assets minus par swap rates. The second component is a comparison between bond cost outs 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 liquidated by the protection seller to the swap buyer.
Example of an Asset Swap
Suppose an investor buys a bond at a dirty cost 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 determined 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). This place the bank pays the investor LIBOR rates plus 0.5% during the swap’s lifetime.