What is a swap of assets?
The primary distinction between an asset swap and a standard swap is the underpinning of the swap contract. Fixed and floating assets are being traded instead of the normal swapping of fixed and floating loan interest rates.
All swaps are derivative agreements between two parties to trade financial instruments. Although these instruments can be nearly anything, swaps often entail cash flows based on a notional principal amount mutually agreed upon. As the name indicates, asset swaps go beyond simple financial flows to exchange assets.
Swaps are typically not used by regular investors or traded on exchanges. Swaps, conversely, are over-the-counter (OTC) agreements between companies or financial institutions.
How to Interpret an Asset Swap
The fixed interest rates of bond coupons can be replaced with variable rates using asset swaps. In this way, they are used to change the cash flow characteristics of underlying assets and to protect against risks related to those assets, such as those related to currency, credit, and interest rates.
An asset swap often entails transactions in which the investor buys a bond stake and then engages in an interest rate swap with the bank that originally sold them the bonds. Investor obtains floating in exchange for a fixed payment. This changes the bond’s fixed coupon into a floating rate depending on LIBOR.
To meet their short-term liabilities (depositor accounts), banks frequently convert their long-term fixed-rate assets to a floating rate. Another function is to protect against financial loss from credit risk, such as the bond issuer defaulting or going bankrupt. In this case, the exchange buyer is also purchasing insurance.
The Asset Swap Procedure
Two distinct trades take place, depending on whether the swap is used to reduce interest rate risk or default risk. The swap seller sells a bond to the buyer in exchange for the filthy price, which is the entire par value plus the accumulated interest.
The two parties then agree to a contract in which the buyer commits to provide the swap seller fixed coupons equivalent to the fixed rate coupons obtained from the bond. In exchange, the swap buyer receives LIBOR payments at variable rates plus (or less) an established fixed spread. This swap’s maturity coincides with the asset’s maturity.
The procedures are the same for the swap buyer intending to hedge default or other event risk. In this case, the swap seller also sells protection while the swap buyer effectively purchases it.
As previously mentioned, in exchange for the hazardous bond’s cash flows (the bond itself is not exchanged), the swap seller (protection seller) will agree to pay the swap buyer (protection buyer) LIBOR plus (or minus) a spread. The swap seller will continue to pay the swap buyer LIBOR plus (or less) the spread in the case of default. The swap buyer has changed its initial risk profile by altering its exposure to interest rates and credit risk.
How is an asset swap’s spread calculated?
The spread for an asset swap is calculated using two factors. The first one equals the value of the underlying asset coupons less the par swap rates. The price that the investor must pay throughout the exchange is determined by comparing bond prices to par values in the second component. The asset swap spread, which the protection seller pays the swap buyer, distinguishes between these two elements.
Illustration of an Asset Swap
Consider a situation where a buyer purchases a bond at an obscene price of 110% to hedge the risk of bond issuer default. For an asset swap, she speaks with a bank. The fixed coupons on the bond are 6% of par. 5% is the swap rate. Assume that the investor will have to pay a 0.5% price premium during the exchange. After that, the asset swap spread is 0.5% (6 – 5 – 0.5). As a result, during the duration of the swap, the bank will pay the investor LIBOR rates + 0.5%.
- A financial instrument with poor cash flow characteristics is swapped out for one with good cash flow characteristics to reduce risk.
- A protection seller obtains cash flows from the bond, and a swap buyer hedges the bond’s risk by purchasing the bond from a protection seller. These are the two participants in an asset swap transaction.
- The overnight rate plus (or minus) a predetermined spread is the asset exchange spread the seller must pay.