EUROPEAN FIXED INCOME RESEARCH

Analytical Research Series

INTRODUCTION TO ASSET SWAPS

Dominic O’Kane

January 2000

Lehman Brothers International (Europe) Pub Code 403

Analytical Research Series January 2000

Summary An asset swap is a synthetic structure which allows an investor to swap

fixed rate payments on a bond to floating rate while maintaining the origi-
nal credit exposure to the fixed rate bond. The pricing of asset swaps is
therefore primarily driven by the credit quality of the issuer and the size of
any potential loss following default. This article gives a simple overview of
the mechanics of asset swaps, explains the risks inherent in the structure
and how these affect the pricing and describes some of the reasons for buy-
ing and selling asset swaps.

Dominic O’Kane
[email protected]
+44 –(207) 260 2628

Acknowledgements The author would like to thank Mark Ames, Jamil Baz, Robert Campbell,
Ugo Calcagnini and Stephane Vanadia for their suggestions and comments.

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Introduction An asset swap enables an investor to buy a fixed rate bond and then hedge
out the interest rate risk by swapping the fixed payments to floating. In
doing so the investor retains the credit risk to the fixed-rate bond and earns
a corresponding return. The asset swap market was born along with the
swap market in the early 1990s. It continues to be most widely used by
banks which use asset swaps to convert their long-term fixed rate assets to
floating rate in order to match their short-term liabilities (depositor ac-
counts).

There are several variations on the asset swap structure with the most widely
traded being the par asset swap. Other types include the market asset swap
and the cross-currency asset swap. We begin by focussing on the most stan-
dard: the par asset swap.

Mechanics of a par A par asset swap is really two separate trades:

asset swap
ΠThe asset swap buyer purchases a bond from the asset swap seller in re-
turn for a full1 price of par.
ΠThe asset swap buyer enters into a swap to pay fixed coupons to the as-
set swap seller equal to the fixed rate coupons received from the bond.
In return the asset swap buyer receives regular payments of Libor plus
(or minus) an agreed fixed spread. The maturity of this swap is the same
as the maturity of the asset.

Figure 1 Mechanics of a par asset swap

At initiation Asset Swap buyer purchases bond worth full price P in return for par

Bond
worth P

Asset Swap Asset Swap

Seller Buyer
100

and enters into an interest rate swap paying a fixed coupon of C in return for LIBOR plus asset swap spread S

C
Asset Swap Asset Swap
Bond
Seller Buyer
LIBOR + S C

If default occurs the asset swap buyer loses the coupon and principal redemption on the bond. The
interest rate swap will continue until bond maturity or can be closed out at market value.

C
Asset Swap Asset Swap
Bond
Seller Buyer
LIBOR + S C

1
Full price, also known as the dirty price, includes the accrued interest.

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This transaction is shown in Figure 1. The fixed spread to Libor paid by the
asset swap seller is known as the asset swap spread and is set at a breakeven
value so the net value of the sale of the bond plus the swap transaction is zero
at inception. In the Appendix we show how to calculate the par asset swap
spread.

The cash flows associated with an example asset swap are shown in Figure 2.
The bond has a maturity date of 20 May 2002, an annual coupon of 5.625%
and is trading at a price of 101.70. The frequency on the floating side is
semi-annual. The breakeven value of the asset swap spread makes the net
present value of all the cash flows equal to par, the up-front price of the asset
swap.

Figure 2 Cashflows of a typical par asset swap

Notional $10,000,000 Bond price 101.70%

Value date 20 October 1999
Floating frequency Semi-annual
Bond maturity 20 May 2002 Floating basis ACT365
Bond coupon 5.625%
Bond frequency Annual Last coupon date 20 May 1999
Bond basis BOND Bond accrued $234,375
Par ASS (bp) 52.40

Cashflow date Fixed coupon Swap fixed Forward Spread Swap

bond side Libor (bp) floating
side

20 Oct 1999
20 Nov 1999 2.742% 52.40 $27,738
20 May 2000 $562,500 $(562,500) 3.771% 52.40 $214,163
20 Nov 2000 3.699% 52.40 $212,905
20 May 2001 $562,500 $(562,500) 4.385% 52.40 $243,409
20 Nov 2001 4.846% 52.40 $270,719
20 May 2002 $10,562,500 $(562,500) 5.312% 52.40 $289,387

Bond full price 104.047%

Fixed side of swap –15.834%
Floating side of swap 11.787%

Total 100.000%

Credit considerations In an asset swap the asset swap buyer takes on the credit risk of the bond.
If the bond defaults, the asset swap buyer has to continue paying on the
swap — which can no longer be funded with the coupon from the bond —
or the swap can be closed out at market value. The asset swap buyer also
loses the par redemption of the bond, receiving whatever recovery rate the
bond issuer pays. As a result the buyer has a default contingent exposure to
the mark-to-market on the swap and to the redemption on the asset. The
buyer is exposed to the loss of the coupons and redemption on the bond -
the difference between the bond price and recovery value. In economic
terms the purpose of the asset swap spread is to compensate the asset swap
buyer for taking these risks.

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Analytical Research Series January 2000

Since the asset swap spread is quoted as a spread to Libor, for assets of better
credit quality than AA-rated banks the asset swap spread may be negative.

Table 1 demonstrates an example of the default contingent risk assumed by

the asset swap buyer. In the example the bond is trading at $90. Assume we
are at the moment just after trade inception so that the value of the swap has
not changed. If the bond defaults with a $10 recovery price, the asset swap
buyer loses $90 as he has just paid par to buy a bond now worth $10. How-
ever he is also the payer of a fixed rate in a swap which is 10 points in his fa-
vour. The net loss is therefore $80, the difference between the full price of
the bond and the recovery price.

Table 1 Asset swap on a discount bond

Bond Swap Total

Value at inception $90 +$10 +$100

Value following default +$10 +$10 +$20
Loss –$80 +$0 –$80

However, consider what happens if the bond is trading 20 points above par
(Table 2). This time if the bond defaults immediately with a recovery price of
$10, the asset swap buyer will have lost a total of $110 - the asset swap buyer
paid par for a bond now worth $10 and is party to a swap which has a nega-
tive mark to market of $20. As a result the investor has actually leveraged his
credit exposure and can lose more than his initial investment. However the
investor is compensated for this with a higher asset swap spread.

For a par bond the maximum loss the asset swap buyer can make is par minus
the recovery price. In terms of expected loss, this makes an asset swap simi-
lar to a default swap spread since a default swap pays out par minus recovery
to the protection buyer following default. It should also make it close to the
value of a par floater spread since the expected loss on a floater which trades
at par is also par minus recovery.

Table 2 Asset swap on a premium bond

Bond Swap Total

Value at inception +$120 –$20 +$100

Value following default +$10 –$20 –$10
Loss –$110 –$0 –$110

However, in practice this comparison is mostly academic since there will be

wide differences between these spreads due to liquidity, availability, market
size, funding costs, supply and demand and counterparty risk.

Interest rate risk of an As time passes and interest rates and credit spreads change, the mark to
asset swap market on the asset swap will change. To understand exactly the sensitivi-
ties of an asset swap, recall that for the asset swap buyer, the different legs
of the trades are

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1. Receive coupons from the bond plus redemption valued off the bond is-
suer curve.
2. Pay coupons on the fixed side of the swap equal in amount to the bond
coupons. Cash flows are present-valued off the Libor curve.
3. Receive payments of Libor plus the asset swap spread from swap coun-
terparty. These payments are priced off the Libor curve.

To best understand the Libor and credit spread sensitivities from the per-
spective of the asset swap buyer, we use the PV01, defined as the change in
price for a one basis point upward shift in the par curve.

For example, consider a 10-year bond with a par floater spread of 50bp and
an annual coupon of 6.0%. As the bond is trading close to par, it will have an
asset swap spread of about 50bp. We use the euro swap curve from 12 Octo-
ber 1999. The PV01 sensitivities are shown in Table 3. The net PV01 is
small but definitely not zero.

Table 3 PV01 sensitivities

Leg PV01

Fixed rate bond –7.540

Swap +7.710
Net +0.170

The key point here is that the sensitivity of the bond price to parallel move-
ments in the yield curve will be less than the sensitivity of the fixed side of
the swap to parallel shifts in the Libor curve. This is only true provided the
issuer curve is above the Libor curve. The asset swap buyer therefore has a
residual exposure to interest rate movements. In practice this sensitivity is
small and only becomes apparent when Libor spreads widen significantly.

The swap rate and Libor spread sensitivity of an asset swap from the per-
spective of the asset swap buyer are summarised in Table 4.

While the sensitivity to changes in Libor swap rates is almost negligible (un-
less Libor spreads are very wide), the sensitivity to changes in the Libor
spread is equivalent to being long the bond.

The asset swap buyer also has an exposure to credit-induced interest rate
risk. If the credit quality of the asset improves so that the asset swap buyer
has a positive mark-to-market, this mark-to-market will have an interest rate
sensitivity which will need to be hedged. In this respect the asset swap is very
much like a floating rate note.

Cashflow matching risk If the asset swap buyer is a bank and is using the structure to match the
outgoing floating rate payments which they make to depositors, the bank
will also be exposed to an unexpected withdrawal of deposits.

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Table 4 Swap rate and Libor spread sensitivity

Event Swap Bond Net

Payments Pay fixed coupon; Receive coupons

receive Libor plus and par redemption
asset swap spread

Swap rates increase Present value of Bond price Small increase due
(Libor spread constant) swap increases decreases to larger PV01 of swap

Swap rates fall (Libor Present value of Bond price Small decrease due
spread constant) swap decreases increases to larger PV01 of swap

Libor spread increases No change Bond price Decrease proportional

(swap rates constant) falls to PV01 of bond

Libor spread falls (swap No change Bond price Increase proportional to

rates constant) increases PV01 of bond

Funding risk Funding also poses a serious risk to the asset swap buyer who will have an
exposure to the cost of funding the asset on balance sheet. If there is a
credit crisis, as there was following the Russian default in late 1998, the
cost of holding the asset may increase and this will reduce the profitability
of the trade.

Counterparty risk An important consideration in par asset swaps is counterparty default risk.
Paying par to buy a bond which is trading at a discount results in the asset
swap buyer having an immediate exposure to the asset swap seller equal to
par minus the bond price. The opposite is true when the bond is trading at a
premium to par. One way to reverse this exposure is to use a market asset
swap structure.

Market asset swap In the market asset swap, the bond is purchased in return for payment of
the full price. The notional of the Libor leg is then scaled by the full price,
and the resulting value of the asset swap spread is different (see the Ap-
pendix). The transaction is shown in Figure 3.

The differences between this and the par asset swap are:

ΠThe bond is purchased at its full price, not for par.

ΠFor a bond trading above par, the counterparty exposure is taken by the
asset swap buyer, and vice-versa. Compare this to the standard asset
swap where the counterparty exposure for a premium bond is taken by
the asset swap seller.
ΠIn a market asset swap the counterparty exposure starts at zero and in-
creases to its maximum at maturity. Compare this to the standard asset
swap package where any counterparty exposure is greatest at initiation
and falls to zero at maturity.
ΠAt the maturity of the market asset swap there is an exchange of par for
the original price of the bond, as shown in Figure 3.

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Figure 3 Market asset swap

At initiation the bond is sold for its full price

Bond
worth P
Seller Buyer
P

Both parties enter into a swap where the notional on the floating side equals the full
market price of the bond

C
Buyer
Seller Bond
C
Libor+ S on notional P

At maturity there is an exchange of

100

Seller Buyer

Note that the credit exposure of a market asset swap remains the same as a
par asset swap.

Uses of asset swaps Clearly the main reason for doing an asset swap is to enable an investor to
take exposure to the credit quality of a bond with minimal interest rate risk.

Tax and accounting reasons may also make it advantageous for investors to
buy and sell non-par assets at par through an asset swap. Asset swaps can be
used to take advantage of mispricings in the floating rate note market.

Variations on asset swaps:

Forward asset swaps It is possible to go long a credit at some future date and at a known price
using forward asset swaps. In this case the investor agrees today to buy the
bond on the forward date at par and then enter into an interest rate swap
where the asset swap spread paid on the floating side has been agreed to-
day. If the bond defaults before the forward date is reached, the asset swap
terminates. The investor does not take on the default risk until the forward
date. Since credit curves are generally upward sloping, a forward asset
swap can often make it cheaper for an investor to go long a credit, on a
forward basis, than to buy the credit today.

Cross-currency Another variation is the cross-currency asset swap. This enables the inves-
asset swaps tor to buy a bond denominated in one currency, pay on the swap in this
currency but receive the floating rate payments in their base currency. The
cash flows are converted at some predefined exchange rate. In this case
there is an exchange of principal at the end of the swap. This structure en-
ables the investor to gain exposure to the credit while reducing their inter-
est rate risk and currency risk.

Callable asset swaps For callable bonds, where the bond issuer has the right to call back the
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bond at a pre-specified price on a sequence of specified dates, an asset

swap buyer will need to be hedged against any loss on the swap since they
will no longer be receiving the coupon from the asset. In this case the asset
swap buyer will want to be able to cancel the swap on any of the call dates
by buying a Bermudan-style receiver swaption. This package is known as a
cancellable asset swap. Most US agency callable bonds are swapped in this
way.

Convertible asset swaps Callable asset swaps may also be used to strip out the credit and equity
components of convertible bonds. Fixed income investors can therefore use
asset swaps to take advantage of the enhanced returns available in the con-
vertible bond market.

The asset swap market is an over-the-counter market where most trades can
be structured to match the needs of the investor. There are, therefore, many
possible variations on the structures described above.

Asset swap spread as a The asset swap spread is a bond specific measure of the expected loss fol-
measure of credit risk lowing default. This is a function of the probability that the issuer defaults,
the price at which the bond is trading and the expected recovery price paid
by the issuer following default. Because it also depends on the price of the
bond, the asset swap spread cannot readily be used for comparing the mar-
ket’s view of credit quality across different bonds and different issuers. The
only way to use the asset swap spread to compare the credit quality of two
issuers is to choose bonds with the same price, and this is not always pos-
sible.

A better measure for comparing the credit quality of different issuers, and for
comparing the relative value of bonds which should have the same credit
quality, is to use the zero volatility spread (ZVS). This is defined as the con-
tinuously compounded spread to the Libor curve which allows us to present
value a bond to its market price. A formal definition is provided in the Ap-
pendix.

In the case when the bond is trading close to par, both the asset swap spread
and the zero volatility spread are close in value, the difference due to the dif-
ferent compounding methodologies.

Summary ΠA par asset swap is a combination of the sale of a bond for par plus an
off-market interest rate swap where the coupon on the fixed leg equals
the coupon on the bond.
ΠIt enables investors to reduce their interest rate risk on a fixed rate bond
while maintaining their exposure to the credit.
ΠIf the bond in the asset swap defaults, the investor loses the par redemp-
tion on the bond (minus any recovery rate) and the mark-to-market on
the swap.
ΠThe asset swap spread on the floating leg compensates the investor for
this default contingent risk.
ΠThe asset swap spread is a bond specific measure of credit risk. For pur-
poses of comparison between issuers, a better choice is the zero volatil-
ity spread.
ΠMarket asset swaps can be used to reduce counterparty risk.

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ΠIn an upward sloping credit curve environment, forward asset swaps can

enable investors to go long a credit more cheaply on a forward basis than
on a cash basis.
ΠCross currency asset swaps enable the investor to eliminate both interest
rate and currency risk.

Appendix

Computing the asset For the purpose of the following, we assume we have constructed a market
swap spread curve of Libor discount factors where z(t) is the price today of $1 to be
paid at time t.

From the perspective of the asset swap seller, they sell the bond for par plus
accrued interest. The net up front payment has a value 100 – P where P is the
full price of the bond in the market. Both parties to the swap are assumed to
be AA bank credit quality and so these cash flows are priced off the Libor
curve. We cancel out the principal payments of par at maturity. For simplic-
ity we assume that all payments are annual and are made on the same dates.
The breakeven asset swap spread A is computed by setting the present value
of all cash flows equal to zero. From the perspective of the asset swap seller
the present value is:

N ( FIXED) N ( FLOAT)

12−3
100 P +C ∑ z( t i ) − ∑ ∆ i (L i + A )z( t i ) = 0
Upfront payment to
purchase asset in 4i =143
142 4
14i =4
1 4424444 3
Fixed payments
Floating payments
return for par 1444444
424444444 3
Interest rate swap

where C equals the annually paid coupon, Li is the Libor rate set at time ti-l
and paid at time ti , ∆i is the accrual factor in the corresponding basis. The
fixed and floating sides may have different frequencies. We solve for the as-
set swap spread A.

On a technical note, when the asset swap is initiated between coupon dates,
the asset swap buyer does not pay the accrued interest explicitly. Effectively,
the full price of the bond is at par. At the next coupon period the asset swap
buyer receives the full coupon on the bond and likewise pays the full coupon
on the swap. However, the floating side payment, which may have a different
frequency and accrual basis to fixed side, is adjusted by the corresponding
accrual factor. Therefore, if we are exactly half way between floating side
coupons, the floating payment received is half of the Libor plus asset swap
spread. This feature prevents the calculated asset swap spread from jumping
as we move forward in time through coupon dates.

Market asset swap In the market asset swap, the net upfront payment is zero. Instead the no-
tional on the Libor side equals the price of the bond and there is an ex-
change of notionals at maturity. Using the notation defined above and us-
ing M to denote the market asset swap spread, from the perspective of the
asset swap seller the present value of all the cashflows is:

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Analytical Research Series January 2000

N ( FIXED) N ( FLOAT)

∑ ∑ ∆ i (L i + M)z( t i ) + (100 − P )z( t N ) = 0

P
C z( t i ) −
100 144244 3
1424 43
i =1 4 14444 i =14244444 3 Final payment
Fixed payments
1 4444444 42Floating
444payments
44444 3
Interest rate swap

A
Solving for M, we find M = 100 .
P

Zero volatility spread The ZVS is the continuously compounded constant spread to the Libor
curve required to re-price a bond. If we denote the ZVS by Θ then we
have:

N ( FIXED)
P=C ∑ z(t i ) exp(− Θ ⋅ t i ) + z(t N ) exp(− Θ ⋅ t N )
i =1

We solve for Θ using a root finding algorithm (Newton-Raphson).

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