Swap spreads hedging

Exhibits 7.5 and 7.6 show relevant spreads for market participants who use Bunds or interest-rate swaps to hedge their holdings. 

The first section describes the motivation for using the swap term structure as a benchmark for pricing and hedging fixed-income securities. The second section examines the factors that affect swap spreads and swap market flows. The third section describes a swap term structure derivation technique designed to mark to market fixed-income products. Finally, different aspects of the derived term structure are discussed. 

Empirically, there are several factors that affect swap spreads. These factors drive swap flows, pricing, and hedging methods of swap markets. The main factors and their impact on swap spreads are described below. 

There are a large number of other factors that can have an impact on swap spreads. Each factor can have varying effects on swap spreads over time. Institutional investors and hedge funds continuously develop forward-looking models that incorporate different factors in an attempt to predict swap spread movements for speculation purposes. 

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. 

This is the traditional strategy that relies on picking names that are expected to outperform the market. In fund management terms, one selects a diversified portfolio of credits, which ensures that systemic market risk (beta) is hedged away, while the performance of the fund generates excess return, or alpha. Names that are expected to outperform are trading at levels that are cheap, in relative value terms, to their industry or sector class. This is measured by the asset swap spread or ASW, as we observed earlier. 

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... 

As discussed above, vanilla swap rates are often quoted as a spread that is a function mainly of the credit spread required by the market over the risk-free government rate. This convention is logical, because government bonds are the principal instrument banks use to hedge their swap books. It is unwieldy, however, when applied to nonstandard tailor-made swaps, each of which has particular characteristics that call for particular spread calculations. As a result, banks use zero-coupon pricing, a standard method that can be applied to all swaps. 

Figure 13.1 specifies that the inverse floater has a minimum coupon on 0 percent. The floor is passed on from the note issuer to the swap bank via the swap. This, in eflfect, caps the note holders LIBOR exposure at 7.875 percent (15.75 divided by two). The bank s swap leaves it exposed to a rise in LIBOR above this level. To be fully hedged, the bank must buy an interest rate cap on LIBOR with a strike rate of 7.875 percent. The cap costs 15 basis points, which explains the spread over the coupon rate in the swap structure. 

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