Asset Swaps: Converting Cash Flow Characteristics and Hedging Risks

What is an asset swap?

Are you familiar with a plain vanilla swap? There is something similar with it in terms of structure, and we call it the asset swap. While they are pretty comparable, they are different in terms of asset swap’s underlying swap contract. Instead of regular loan interest rates, which are fixed, floating, and being swapped, there is an exchange in the fixed and floating assets.

Generally, swaps are derivative contracts. Two parties exchange financial instruments, and they are almost practically anything. However, they will most likely involve cash flows depending on a notional principal amount where both parties agreed. Asset swaps refer to actual asset exchanges rather than regular cash flows. They are not traded on exchanges. Also, retail investors will not most likely get in touch with swaps. Instead, we encounter them usually as over-the-counter contracts between businesses or institutions. Hence, something bigger than an individual retail investor.

Learning the basics

Are you overlaying fixed interest of bond coupons that come with floating rates? In that case, you can use asset swaps. They help in converting cash flow characteristics of underlying assets. On the other hand, they also transform them to hedge risks of the asset. It may be related to currency, interest rates, or credits. Asset swaps are relative to transactions where the investor acquires a bond position then enters interest rate swaps with the selling bank. The payment is fixed to receive a floating. This converts a bond-fixed coupon into a LIBOR-based floating coupon. Many banks use this when converting long-term fixed asset rates into floating ones. Hence, it matches their short-term liabilities. And when we say short-term liabilities, we refer to the depositor accounts. Aside from that, it is also used for insurance against loss that came from credit risks of the bond’s issuer. For instance, we have bankruptcy or default. In this sense, the swap buyer is also buying protection.

Tell me more about asset swaps.

We have two trades in an asset swap regardless of the reason why it’s being done. It does not matter if it is done for hedging interest rates or default risks. Let’s start with the buyer that purchases the bond for a total price par and accrued interest rate. Some people call this the dirty price. Then, the buyer and the seller agree on a contract. The buyer shall pay fixed coupons to the swap seller. It should be equal to the fixed-rate coupons from the bond. What will the swap buyer get out of this? He receives a variable rate payment of LIBOR. There are times when a fixed spread is added or subtracted from this LIBOR. The maturity of the asset and swap is always similar. We said earlier that the reason for doing this does not matter. A buyer who wants to hedge default and a buyer who has another reason follows the same mechanics.

The swap seller, also known as the protection seller, shall pay the swap buyer LIBOR. This LIBOR may come with an additional or a subtracted spread in return or the risky bond’s cash flows. Take note that the bond will never change hands. If a default happens, the swap buyer shall not stop receiving LIBOR plus or minus the swap seller’s spread. If this is the case, the swap buyer converted the original risk profile when changing the interest rate and credit risk exposure.

The calculation before we close

We can calculate asset swaps using two components. First, we have the difference between the underlying asset’s value of coupons and the par swap rates. Next, we can compare the bond prices and par values to know the investor’s price throughout the swap’s lifetime. If we get the difference between these two components, we can arrive with the asset swap spread that the swap seller pays to the swap buyer.