An asset swap is a type of derivative contract that allows two parties to exchange different types of assets, such as fixed and floating ones. The purpose of an asset swap is to change the cash flow characteristics of the reference asset, usually a bond, to hedge against various risks, such as interest rate risk or credit risk.
To construct an asset swap, the following steps are involved:
- The swap buyer purchases a bond from the swap seller for the full price, which includes the par value and the accrued interest. This is called the dirty price of the bond.
- The swap buyer and seller enter into an interest rate swap contract, where the buyer agrees to pay fixed coupons to the 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 a fixed spread. This spread is determined by the difference between the coupon values of the bond and the market rate, as well as the premium or discount of the clean price (the price without the accrued interest) compared to the par value.
- The swap contract has the same maturity as the bond. This means that if the bond defaults, the swap buyer will still receive the variable rate payments from the swap seller until the end of the contract.
An asset swap can be used to transform a fixed rate bond into a floating rate bond, or vice versa. It can also be used to hedge against the credit risk of the bond issuer, by transferring the ownership of the bond to the swap seller, who assumes the default risk. The swap buyer, on the other hand, receives a floating rate that reflects the credit quality of the swap seller, usually a bank or a financial institution.
An example of an asset swap is as follows:
- A swap buyer wants to buy a 10-year corporate bond with a 5% coupon rate, but is concerned about the credit risk of the bond issuer, who might default in the future.
- The swap buyer buys the bond from the swap seller for $100,000, which is the par value plus the accrued interest of $2,500.
- The swap buyer and seller agree to an interest rate swap, where the buyer pays fixed coupons of 5% to the seller, and receives variable rate payments of LIBOR + 0.5% from the seller. The spread of 0.5% is based on the difference between the bond coupon and the market rate, as well as the premium of the clean price ($98,000) over the par value.
- The swap contract lasts for 10 years, the same as the bond maturity. If the bond issuer defaults, the swap buyer will lose the bond principal, but will continue to receive the variable rate payments from the swap seller. The swap seller, on the other hand, will keep the bond and bear the default risk.
Basic Theory
The primary objective of an asset swap is to enhance the yield or overall return on a fixed income investment. This is achieved by exchanging the fixed interest rate of a bond for a floating interest rate, typically based on a benchmark such as LIBOR. The investor receives the fixed coupon payments from the bond issuer and pays a variable rate to the swap counterparty.
The basic components of an asset swap include the fixed-rate bond, the floating-rate payment, and the swap spread. The swap spread is the difference between the fixed-rate bond yield and the variable rate paid in the swap.
Procedures
- Identify the Fixed-Rate Bond: Choose a fixed-rate bond as the underlying security for the asset swap. This could be a corporate bond, government bond, or any other fixed-income instrument.
- Select a Benchmark: Decide on a benchmark for the variable interest rate in the swap. Common benchmarks include LIBOR or the government bond yield.
- Find a Swap Counterparty: Locate a swap counterparty willing to engage in the transaction. This can be a financial institution or another investor.
- Determine Swap Spread: Calculate the swap spread by finding the difference between the fixed-rate bond yield and the variable rate payment in the swap.
- Execute the Asset Swap: Enter into an agreement with the swap counterparty, specifying the terms of the asset swap, including payment frequency and dates.
Explanation with Scenario
Let’s consider a scenario with the following details:
- Fixed-Rate Bond: XYZ Corporation 5% coupon bond with a face value of $1,000 and a maturity of 5 years.
- Benchmark: 3-month LIBOR.
- Swap Counterparty: ABC Bank.
- Current Yield on XYZ Corporation Bond: 4%.
Calculation in Excel
- Calculate Fixed Bond Cash Flows:
| Year | Coupon Payment | Face Value Payment |
|---|---|---|
| 1 | $50 | – |
| 2 | $50 | – |
| 3 | $50 | – |
| 4 | $50 | – |
| 5 | $50 | $1,000 |
- Determine Variable Rate Payments:
| Year | Variable Rate Payment |
|---|---|
| 1 | $12.50 |
| 2 | $12.50 |
| 3 | $12.50 |
| 4 | $12.50 |
| 5 | $12.50 |
- Calculate Swap Spread:
Swap Spread = Current Yield on Fixed Bond – Variable Rate (LIBOR)
Swap Spread = 4% – 2% = 2%
- Execute Asset Swap in Excel:
Set up a cash flow table combining the fixed bond cash flows and the variable rate payments.
| Year | Fixed Bond Cash Flow | Variable Rate Payment | Net Cash Flow |
|---|---|---|---|
| 1 | $50 | -$12.50 | $37.50 |
| 2 | $50 | -$12.50 | $37.50 |
| 3 | $50 | -$12.50 | $37.50 |
| 4 | $50 | -$12.50 | $37.50 |
| 5 | $1,050 | $1,012.50 | $2,062.50 |
Result
In this scenario, the investor receives enhanced cash flows through the asset swap, gaining $2,062.50 in the final year compared to the fixed bond alone.
Other Approaches
- Credit Default Swap (CDS): Instead of a plain vanilla asset swap, investors may use a credit default swap to enhance returns and manage credit risk.
- Interest Rate Swap: Swap fixed interest payments for floating rates without involving an underlying bond.
