Assets asset swaps

Asset-Swap Spreads and Relative Value Analysis... 

Asset-swap spread 1 1.5 Analysis using market ... 

The asset swap is an agreement that allows investors to exchange or swap future cash flows generated by an asset, usually fixed rates to floating rates. It is essentially a combination of a fixed coupon bond and an IRS. We define it thus ... 

An asset swap is a synthetically created structure combining a fixed coupon bond with a fixed-floating IRS, which then transforms the bond s swap fixed rate payments to floating rate. The investor retains the original credit exposure to the fixed... 

The spread of the floating coupon over the bond s market price, that is the asset-swap value is the difference between the bond s market price and par. The package of the asset swap is structured in two phases ... 

At the same time, the investor enters in the swap contract, paying fixed cash flows equal to the coupon payment and receiving a fixed spread over the interbank rate, that is the asset-swap spread. Figure 1.1 shows the asset-swap mechanism. 

The zero-coupon curve is used in the asset-swap analysis, in which the curve is derived from the swap curve. Then, the asset-swap spread is the spread that allows us to receive the equivalence between the present value of cash flows and the current market price of the bond. 

In an asset-swap contract, the investor assumes the credit risk of the bond. In case the bond defaults, the investor will continue to pay the swap, without... 

Making comparison between bonds could be difficult and several aspects must be considered. One of these is the bond s maturity. For instance, we know that the yield for a bond that matures in 10 years is not the same compared to the one that matures in 30 years. Therefore, it is important to have a reference yield curve and smooth that for comparison purposes. However, there are other features that affect the bond s comparison such as coupon size and structure, liquidity, embedded options and others. These other features increase the curve fitting and the bond s comparison analysis. In this case, the swap curve represents an objective tool to understand the richness and cheapness in bond market. According to O Kane and Sen (2005), the asset-swap spread is calculated as the difference between the bond s value on the par swap curve and the bond s market value, divided by the sensitivity of 1 bp over the par swap. 

As shown in Eigures 1.4 and 1.5, with this swap structuring, the asset-swap spread for HERIM is 39.5 bp and for TKAAV is 39.1 bp. These represent the spreads that will be received if each bond is purchased as an asset-swap package. In other words, the ASW spread provides a measure of the difference between the market price of the bond and the value of the cash flows evaluated using zero-coupon rates. 

However, a critical issue on this spread measure is how the asset swap has been stmctured. ASW measure works very well when bond prices trade at or near to par. Most corporate bonds trade with price away from the par (as in this case), thus making the ASW an inaccurate spread measure. If the bond trades at premium, the ASW spread will overestimate the level of credit risk conversely, if the bond trades at discount the ASW spread will underestimate the level of credit risk. Therefore, in the case of HERIM and TKAAV, the ASW spread overestimates the credit risk associated with the bonds because both trade significantly at premium. 

A credit default swap (CDS) price provides fundamental credit risk information of a specific reference entity or asset. As explained before, asset swaps are used to transform the cash flows of a corporate bond for interest rate hedging purpose. Since the asset swaps are priced at a spread over the interbank rate, the ASW spread is the credit risk of the same one. However, market evidence shows that credit default swaps trade at a different level to asset swaps due to technical... 

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 1.7 Historical asset-swap spread for bonds traded in the utility industry. (Data Source Bloomberg.)... 

We assume we have constructed a market curve of Libor discount factors where Df(t) is the price today of 1 to be paid at time t. From the perspective of the asset swap seller, it sells the bond for par plus accrued interest. The net up-front payment has a value 100 F where P is the market price of the bond. If we assume both parties to the swap are interbank credit quality, we can price the cash flows off the Libor curve. 

For the calculation, we cancel out the principal payments of par at maturity. We assume that cash flows are annual and take place on the same coupon dates. The breakeven asset-swap spread A is calculated by setting the present value of all cash flows equal to 0. From the perspective of the asset swap seller, the present value is ... 

Gale, G., May 2006. Using and trading asset-swaps interest rate strategy. Morgan Stanley Fixed... 

Asset-swap spread It is determined by combining an interest-rate swap and cash bond. Generally, bonds pay fixed coupons therefore, it will be combined with an interest-rate swap in which the bondholder pays fixed coupons and receives floating coupons. The spread of the floating coupon over an interbank rate is the asset-swap spread. ... 

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. 

Chapter 8 shows several spread measures that can be used to compare fixed-rate bonds. Conventionally for floating-rate notes, traders use the discounted margin. To analyse a floating-rate note with a fixed-rate note, one method is to compare the discounted margin of a floater with the asset swap spread of fixed-rate bonds. 

What is worthy then of a further investment of cash to purchase this second edition Hopefully the new chapters on asset swap spread relative value, convertible bonds, callable/putable bonds and floating-rate notes will be sufficient justification additionally we have updated the previous chapters on inflation-linked bonds and risky corporate bonds valuation. We have also included Excel spreadsheets that enable the reader to apply the analysis described in the chapters right away to bonds that he or she selects. 

Credit Derivatives are a relatively recent addition to the range of financial instruments used by banks and financial institutions. However, there has been strong growth in this innovative area of the capital markets. The British Bankers Association (BBA) estimates that at the end of 2001 the global market (excluding asset swaps) accounted for over 1 trillion. The projected growth rate for the global credit derivatives market is predicted to reach a 4.8 trillion by 2004. 

Asset swaps predate the introduction of the other instruments we discuss in this chapter and strictly speaking are not credit derivatives. However, they are used for similar purposes and there is considerable interplay between the cash and synthetic markets using asset swaps, hence the need to discuss them here. 

Asset swaps are used to alter the cash flow profile of a bond. The asset swap market is an important segment of the credit derivatives market since it explicitly sets out the price of credit as a spread over LIBOR. Pricing a bond by reference to LIBOR is commonly used and the spread over LIBOR is a measure of credit risk in the cash flow of the underlying... 

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. 

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