What Is an Asset Swap?
An asset swap is comparative in structure to a plain vanilla swap with the key difference being the underlying of the swap contract. Rather than standard fixed and floating loan interest rates being swapped, fixed and floating assets are being exchanged.
All swaps are derivative contracts through which two parties exchange financial instruments. There's really nothing that these instruments can't be nearly, yet most swaps include cash flows in light of a notional principal amount agreed upon by the two players. As the name proposes, asset swaps include a real asset exchange rather than just cash flows.
Swaps don't trade on exchanges, and retail investors don't generally participate in swaps. Rather, swaps are over-the-counter (OTC) contracts between organizations or financial institutions.
Understanding an Asset Swap
Asset swaps can be utilized to overlay the fixed interest rates of bond coupons with floating rates. In that sense, they are utilized to transform cash flow qualities of underlying assets and transforming them to hedge the asset's risks, whether connected with currency, credit, as well as interest rates.
Regularly, an asset swap includes transactions in which the investor gains a bond position and afterward goes into a interest rate swap with the bank that sold them the bond. The investor pays fixed and receives floating. This transforms the fixed coupon of the bond into a LIBOR-based floating coupon.
It is widely utilized by banks to switch their long-term fixed rate assets over completely to a floating rate to match their short-term liabilities (investor accounts).
Another utilization is to protect against misfortune due to credit risk, like default or bankruptcy, of the bond's issuer. Here, the swap buyer is likewise buying protection.
The Process of an Asset Swap
Whether the swap is to hedge interest rate risk or default risk, there are two separate trades that happen.
To begin with, the swap buyer purchases a bond from the swap seller in return at a full cost of par plus accrued interest (called the dirty price).
Next, the two parties make a contract where the buyer consents to pay fixed coupons to the swap seller equivalent to the fixed rate coupons received from the bond. In return, the swap buyer receives variable rate payments of LIBOR plus (or minus) an agreed-upon fixed spread. The maturity of this swap is equivalent to the maturity of the asset.
The mechanics are no different for the swap buyer wishing to hedge default or some other event risk. Here, the swap buyer is basically buying protection and the swap seller is likewise selling that protection.
As before, the swap seller (protection seller) will consent to pay the swap buyer (protection buyer) LIBOR plus (or minus) a spread in return for the cash flows of the risky bond (the bond itself doesn't change hands). In the event of default, the swap buyer will keep on getting LIBOR plus (or minus) the spread from the swap seller. Along these lines, the swap buyer has transformed its original risk profile by changing the two its interest rate and credit risk exposure.
Due to recent embarrassments and inquiries around its legitimacy as a benchmark rate, LIBOR is being phased out. As per the Federal Reserve and regulators in the U.K., LIBOR will be phased out by June 30, 2023, and will be supplanted by the Secured Overnight Financing Rate (SOFR). As part of this stage out, LIBOR one-week and two-month USD LIBOR rates will as of now not be distributed after Dec. 31, 2021.
How Is the Spread of an Asset Swap Calculated?
There are two parts utilized in working out the spread for an asset swap. The first is the value of coupons of underlying assets minus par swap rates. The subsequent part is a comparison between bond prices and par values to determine the price that the investor needs to pay over the lifetime of the swap. The difference between these two parts is the asset swap spread paid by the protection seller to the swap buyer.
Illustration of an Asset Swap
Assume an investor purchases a bond at a dirty price of every available ounce of effort and needs to hedge the risk of a default by the bond issuer. She contacts a bank for an asset swap. The bond's fixed coupons are 6% of par value. The swap rate is 5%. Expect that the investor needs to pay 0.5% price premium during the swap's lifetime. Then the asset swap spread is 0.5% (6 - 5 - 0.5). Thus the bank pays the investor LIBOR rates plus 0.5% during the swap's lifetime.
- An asset swap is utilized to transform cash flow qualities to hedge risks from one financial instrument with unwanted cash flow attributes into another with good cash flow.
- The seller pays an asset swap spread, which is equivalent to the overnight rate plus (or minus) a pre-calculated spread.
- There are two parties in an asset swap transaction: a protection seller, which receives cash flows from the bond, and a swap buyer, which hedges risk associated with the bond by selling it to a protection seller.