Asset Swap
What is an asset swap?
An asset swap combines a fixed-rate credit risk obligation with a floating fixed-rate swap, which transforms the obligation into a floating rate obligation (FRN). The investor receives the relevant interbank benchmark plus a spread which is fixed at the start of the swap agreement and often purchased by credit-oriented investors such as hedge funds, mutual funds and large institutions financial.
- Difference between the bond market price and its face value.
- Difference between bond coupon and market swap rate.
Types of asset trading structure
There are two types, which are as follows.
1 - Cross Currency Swap
This is a combination of bond purchases and currency swaps. It is a combination of 3 elements:
Purchase of fixed-rate bonds
Fixed IRS payment in the same currency as the bond
Currency swaps to pay floating coupons in foreign currency and receive floating coupons in national currency.
For example, investors may consider buying corporate bonds in a non-domestic currency and then engaging in currency swap transactions to create a synthetic FRN in the domestic currency.
If the resulting spread is higher than the spreads available on domestic currency bonds / FRNs of the same issuer, a profit will result.
2 - Liability Swap
Bond investors use very similarly, but opposite transactions to exploit anomalies that will provide the cheapest source of funding in domestic and international bond and capital markets, often described as liability swaps. They are structured by borrowing companies seeking to obtain the cheapest loans in the national or international markets.
Motivation Behind those Swaps
Some of the essential motivations for investors are.
#1 – Leverage
Such investor commonly seems for leveraged exposure supply on a floating foundation. The price of investment borne through the investor is pivotal to asset change transactions. The deal is normally compared to unfunded alternatives, inclusive of the opportunity of promoting CDS safety at the identical reference entity.
#2 – Credit Spread Opportunities
The principal motivation in the back of taking publicity on a relative price foundation is to gain the goal credit score unfold. Investors typically do now no longer preserve easy accrual product until adulthood and regularly tries to liquidate them by getting into a contrary transaction with precise comparable phrases because of the preceding one which offset the publicity. Such a change gives the funded investor an advanced internet credit score unfold to CDS at the identical reference asset.
Key Risks Faced through an Investor in Asset Swap
Here are the dangers which can be confronted by an investor.
The such investor is seeking to earn the correct unfold for the chance of bond issuer default. An investor typically compares the unfold to be had from this change to the ones to be had from equal chance FRN or Credit default change.
The asset change investor buys an illiquid package deal investment. There isn’t any quoted marketplace rate for this type of change. The most effective and sensible manner to liquidate its miles is through terminating the change at a mark to marketplace price and promoting the bond. However, there may be no assurance that the phrases of such unwind will yield proper results.
This risk is negligible for investment-grade asset swaps and real for high-yield transactions. Failure of the bond could leave the swap investor to settle the transaction on terms that cannot be anticipated.
These are the risks that the market’s credit spread will narrow or widen in response to a change in market sentiment on the insolvency of the issuer or a change in the rating of the instruments.
Margin requirements involve another set of risks for asset swap investors. The change in the OIS and LIBOR curve leads to changes in the margin which should be roughly offset by changes in bond interest rate sensitivity. However, the change in the value of the swaps is monetized (through margin payments), but any change in the value of the bond is not realized. This may leave the swap investor with a negative market value on the swap, which is offset by an unrealized gain on the bonds
Advantages
These swaps offer borrowers the possibility of converting their exposure into national currency or foreign currency at variable rates.
Asset swapping has become a more useful method for making a relative value comparison. This allows the borrower and investor to compare bonds on a relative basis and describe them as cheap or expensive.
The notional amount of these transactions is now widely used for comparison purposes and its credit spreads have become an expression of funding costs and target investment returns.
As the exchange of assets and liabilities has become a central element of international finance, it allows an investor to earn higher margins than national inter-bank money market indices.
Disadvantages
Some of the disadvantages are as follows.
It is more complex than simple securities such as bonds and notes. For such an exchange to be created, there must be a reason to buy them preferably on simple FRNs.
In many cases, an asset swap is an arbitrage transaction that involves taking exposure to fixed coupon bonds and creating nearly equal synthetic FRNs from them, but if this often involves taking huge risks from investors by taking advantage of their exposure
Conclusion
Asset Swap is the combination of bond purchase and fixed Interest rate swap. This swap is not a distinct product but a set of products defined by the motivation behind the transaction.
