Swap spreads structures

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 ... 

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. 

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. 

Since credit default swaps are written on the reference entities, their pricing provide information on the default probabilities of the issuer and are not subject to liquidity premia that can be present in the credit spreads of the credit risky bonds. Therefore, the term structure of credit default swap spreads for a particular issuer is used to determine the cumulative default probability of the issuer. 

Eigures 1.4 and 1.5 show the Bloomberg screen for ASW analysis. To calculate the ASW spread, we use the bond s price, which is equal to 115.138 for HERIM and 114.592 for TKAAV. The swap structuring has been performed as follows ... 

Truck, S., Laub, M., Rachev, S.T., 2004 The terms structure of credit spreads and credit default swaps - an empirical investigation. Working Paper, September. 

Strictly speaking, the FIAT 1 transaction does not generate excess spread. This explains the high level of credit enhancement from the unrated class M notes (usually, unrated tranches are either privately sold or kept as an equity tranche by the originator). On the closing date, an amount of notes was issued which was equal to the net present value of all future cash payments due from the collateral (as opposed to the principal balance of the collateral). The discount rate used was the fixed rate payable to the swap counterparty (swap rate plus coupon on the class A notes and all fees associated with the transaction). Structured this way, the receivables always yield the discount rate, leaving no excess spread in the transaction. However, losses on the FIAT 1 portfolio can be covered to a certain degree from interest collections because the structure provides for delinquent principal and defaults to be covered before interest is paid on the class M notes. 

The credit curves (or default swap curves) reflect the term structure of spreads by maturity (or tenor) in the credit default swap markets. The shape of the credit curves are influenced by the demand and supply for credit protection in the credit default swaps market and reflect the credit quality of the reference entities (both specific and systematic risk). The changing levels of credit curves provide traders and arbitragers with the opportunity to measure relative value and establish credit positions. 

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. 

Notes issued in synthetic structures are organized by tranche. With the proceeds from the notes it issues to investors, the SPV purchases high-quality (AAA) liquid securities—for example, U.S. Treasuries, bank asset-backed paper such as credit card ABS, and German bonds, such as Pfandbriefe —to serve as collateral. This collateral will generate LIBOR-related interest and principal cash flows that the SPV passes on to the investors together with the swap premium, which creates an additional credit spread on the notes. The cash flows from the collateral may not match the payments due on the issued notes—for example, the bonds used as collateral may pay a flxed rate and the issued notes a floating one. To remedy this, the... 

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