Asset Swaps

Published: 15th October 2009
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DESCRIPTION

An Asset Swap is an Interest Rate Swap or Cross Currency Swap used to convert the cashflows from and underlying security (a Bond or Floating Rate Note ), from Fixed coupon to Floating coupon, Floating coupon to Fixed Coupon, or from one currency to another. The terms and conditions of the Asset Swap are the same as for an Interest Rate Swap or Cross Currency Swap. The underlying security and swap may be transacted together (as a package) with the same counterparty or separately with different counterparts. The Asset Swap may be transacted at the time of the security purchase or added to an bond or FRN already owned by the investor. A Fixed Rate Bond plus an Asset Swap converting the bond to floating rate is known as a Synthetic Floating Rate Note. The security plus Asset Swap can be sold as a package, or separately.

An Asset Swap is an agreement between two parties to exchange interest payments. However, an Asset Swap is unique in that one interest payment is tied to cash flows from an investment, such as corporate bonds or notes with fixed coupons. The other payment is typically tied to an alternative index, such as a floating rate or a rate denominated in a different currency.

EXAMPLE 1

Asset swaps are commonly used by investors who seek to transform the cash flows of an asset or pool of assets without affecting the underlying investment position. For instance, suppose a U.S. fund manager want to own a particular Euro-denominated fixed rate issue, but prefers to receive floating rate US dollar cash flows. The investor could purchase the bond and then enter into asset swap to receive 6 month US LIBOR payments (+/- spread) in return for paying a fixed rate coupon in Euros.

The swap would be adjusted to par such that the fixed payments on the swap match the fixed payments on bond. The net result is that the fund manager owns the desired investment with the desired cash flows.

Foreign exchange and interest rate derivatives involve a high degree of risk including, but not limited to, loss of principal, and may not be suitable for all investors or customers.

EXAMPLE 2

An investor believes CAD rates will rise over the medium term. They would like to purchase CAD 50million 5yr Floating Rate Notes. There are no 5yr FRNs available in the market in sufficient size. The investor is aware of XYZ Ltd 5yr 6.0% annual fixed coupon Bonds currently trading at a yield of 5.0%. The bonds are currently priced at 104.38. The investor can purchase CAD 50million Fixed Rate Bonds in the market for a total consideration of CAD 51,955,000 plus any accrued interest. They can then enter a 5 year Interest Rate Swap (paying fixed) with the Bank as follows:

Notional:
CAD 50,000,000

Investor Pays:
6.0% annual Fixed (the coupons on the bond)

Investor Receives:
LIBOR plus say 50bp

Up front Payment:
The Bank Pays CAD 1,955,000 plus accrued bond interest to investor

The up front payment compensates the investor for any premium paid for the bonds. Likewise, if the bonds were purchased at a discount, the investor would pay the discount amount to the Bank. This up front payment ensures that the net position created by the Asset Swap is the same as a FRN issued at par so that the initial outlay by the investor is CAD 50million.

PRICING

The Asset Swap is priced using the same methodology as the Interest Rate Swap. From the investors viewpoint, the net cashflows from the Bond plus the Asset Swap are the same as the cashflows from a Floating Rate Note. The yield on the Asset Swap (in the example LIBOR plus 50bp), will depend upon the relationship between the Bond yield and the Swap Yield for that currency. When converting a fixed rate bond to floating rate, LOWER swap rates relative to bond yields will result in HIGHER Asset Swap yields. When converting FRNs to fixed rate, HIGHER swap rates relative to bond yields will result in HIGHER Asset Swap yields.

It is a common mistake to assume that the yield over LIBOR on the Asset Swap (50bp in the example above) is merely the difference between the Bond Yield (5%) and the 5yr Swap yield. While the two instruments have the same maturity, they have different yields and therefore different durations. It is therefore necessary to price the Asset Swap using a complete Interest Rate Swap pricing model.

TARGET MARKET

Any investor purchasing or holding interest bearing securities. The Asset Swap can either be used to create synthetic securities unavailable in the market, or as an overlay interest rate management technique for existing portfolios. Many investors use Asset Swaps to "arbitrage" the credit markets, as in many instances synthetic FRNs or Bonds produce premium yields compared to traditional securities issued by the same company. It should be noted that some of this premium yield is due to the added complexity of these transactions, albeit slight, and the additional documentation, required (i.e. ISDA).



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