Asset swaps basis

Asset Swap Basis The asset swap basis is the spread on the CDS minus the spread on a par asset swap of a bond with a similar average life. A positive basis exists when this difference is positive. 

Several borrowers issue bonds in multiple currencies, which tend to trade at different spreads, even on a fully asset swapped basis. The reasons for this divergence include name recognition, and technical factors such as liquidity and the ability to enter into a repo. 

If this difference is positive we have a positive basis, and it happens when credit derivates trade at higher prices than asset swaps. Otherwise, if the difference is negative we have a negative basis. Consider the following example of a positive basis trade for HERIM and TKAAV. For both bonds, we calculate the CDS spread which is equal to 86.3 for HERIM and equal to 88.6 for TKAAV. The CDS basis over the ASW spread determined before is equal to 46.8 for HERIM and equal to 49.5 for TKAAV. However, the basis illustrated in Figure 1.6 is different because CRVD measures them relative to the Z-spread, which is 50.7 for HERIM and 48 for TKAAV. The basis relative to the Z-spread is equal to 35.6 for HERIM and 40.6 for TKAAV. So, we note that either the ASW spread or the Z-spread can be used as the basis performance, giving a similar result and positive basis in both cases. 

Figure 8.2 shows the Bloomberg YAS page for Tesco bond SVi% 2019, as at October 9, 2014. The bond has a price of 109.345 and yield to maturity of 3.46%. On the date, the yield spread over a government bond benchmark UK 41 % Treasury 2019 is 200 basis points. The G-spread over an interpolated government bond is 181.5 basis points. Conventionally, the difference between these two spreads is narrow. We see also that the asset-swap spread is 173.6 basis points and Z-spread is 166.3 basis points. 

An example would be that a protection buyer holding a fixed-rate risky bond and wishes to hedge the credit risk of this position via a credit default swap. However, by means of an asset swap the protection seller (e.g., a bank) will agree to pay the protection buyer LIBOR +/-spread in return for the cash flows of the risky bond. In this way the protection buyer (investor) may be able to explicitly finance the credit default swap premium from the asset swap spread income if there is a negative basis between them. If the asset swap was terminated, it is common for the buyer of the asset swap package to take the unwind cost of the interest rate swap. 

Assume the reference entity also has an issued bond (which we can assume is eligible for delivery under the credit default swap contract). However, if the asset swap level of this bond is LIBOR plus 55 bps p.a. and an investor funds at LIBOR plus 5 bps p.a., the investor in the bond would pick up 50 bps p.a. holding the bond. However, this return would be less than the credit default swap premium on the same bond. The investor could generate more value from this positive basis, then asset swapping and holding the bond. 

However, it is also possible that an investor may find that there is a negative basis. For example, the credit default swap spread is less than the asset swap level for a cash instrument issued by the same reference entity. This situation may arise in the markets ... 

Asset-swap pricing is commonly applied to credit-default swaps, especially by risk management departments seeking to price the transactions held on credit traders book. A par asset swap typically combines an interest rate swap with the sale of an asset, such as a fixed-rate corporate bond, at par and with no interest accrued. The coupon on the bond is paid in return for LIBOR plus, if necessary, a spread, known as the asset-swap spread. This spread is the price of the asset swap. It is a function of the credit risk of the underlying asset. That makes it suitable as the basis for the price payable on a credit default swap written on that asset. 

Return from a holding of fixed-income securities may be measured in more than one way. The most common approach is to consider the asset-swap spread. More sophisticated investors also consider the basis spread between the cash bond and the same-name credit default swap price, which is known as the basis. In this chapter we consider the most accessible way to measure bond return. 

In this section we consider the Treasury spread, asset swap spread, Z-spread, and basis. 

An asset swap is a package that combines an interest-rate swap with a cash bond, the effect of the combined package being able to transform the interest-rate basis of the bond. Typically, a fixed-rate bond will be combined with an interest-rate swap in which the bond holder pays fixed coupon and received floating coupon. The floating coupon will be a spread over LIBOR (see Choudhry et al. 2001). This spread is the asset-swap spread and is a function of the credit risk of the bond over and above interbank credit risk. Asset swaps may be transacted at par or at the bond s market price, usually par. This means that the asset swap value is made up of the difference between the bond s market price and par, as well as the difference between the bond coupon and the swap flxed rate. 

FIGURE 19.3 shows the Bloomberg screen ASW for a GBP-denomi-nated bond, GKN Holdings 7 percent 2012, as of August 10, 2005- We see that the asset-swap spread is 121.5 basis points. This is the spread over LIBOR that will be received if the bond is purchased in an asset-swap package. In essence, the asset swap spread measures a difference between the... 

Put simply, the Z-spread is the basis point spread that would need to be added to the implied spot yield curve such that the discounted cash flows of the bond are equal to its present value (its current market price). Each bond cash flow is discounted by the relevant spot rate for its maturity term. How does this differ from the conventional asset-swap spread Essentially, in its use of zero-coupon rates when assigning a value to a bond. Each cash flow is discounted using its own particular zero-coupon rate. The bond s price at any time can be taken to be the market s value... 

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