Updated July 14, 2023
Definition of Asset Swaps
Asset Swaps mean a derivative contract entered into between two parties (swap buyer and protection seller) over-the-counter to exchange the fixed and floating assets wherein the buyer first acquires a bond and then agrees with swap seller to receive cash flows in the nature of LIBOR-based floating characteristics and will pay a fixed amount to the swap seller.
- Swap means to exchange. Asset swap means exchanging assets for different cash flow characteristics.
- Consider the situation of a banking institution that has held deposit holders’ money. The deposit holders may demand money at any time. Thus, a banker has to ensure that it has minimum sufficient funds available to meet the deposit holder’s short-term needs.
- Consider a similar situation from an investor who wants a floating income instead of a fixed-income asset. Here is where a swap of assets comes into play.
- So basically, the investor will enter into a swap with a banker to pay a fixed income to the banker, and in return, the banker will pay a floating income to the investor. Here, the banker is hedged for meeting its short-term commitments.
- Asset swap exchanges the financial assets (a fixed asset and another a floating asset) between two parties to exchange required cash flows.
- The objective of an asset swap is to hedge against different types of risks, including the risk of interest rate, risk of default by the bond issuer, credibility risk, etc.
- These transactions are customized to the needs to swap buyers and seller and are generally made by financial institutions. So, these transactions do not occur in exchange but are traded over the counter.
How Does It Work?
- Consider the following flow chart:
Image Created using: https://lucid.app/lucidchart/61a0fbee-24a8-4096-b800-ce90bcfae1bf/edit?page=0_0#.
- The swap buyer is an investor afraid of a bond issuer’s default. It wants to protect its investment. So as a first step, the investor will buy a bond by paying a dirty price (full price of the bond plus interest accrued from the last interest payment date). The risk of the bond depends on the risk rating issued by rating agencies.
- Next, the investor wants to protect its investment and thus enters into a swap contract with a prospective swap seller (normally a banking institution). The banker understands the rating and credibility of the bonds issued to the investor.
- The parties to the swap enter into an agreement to decide upon the terms of the exchange of cash flows.
- The investor is receiving fixed coupons from the bond issuer. On each payment date, the investor will pass on the fixed coupons to the seller, and the seller will pay the buyer a floating rate (LIBOR plus something).
- This goes on and on until maturity. In case of default by the bond issuer, the investor will not receive the fixed coupons, and thus, it would not be able to pay those fixed coupons to a banking institution. However, as a term of trade, the banker would still be obliged to pay a LIBOR-based floating rate to the investor.
- Thus, the investor is hedged against the credit risk.
Examples of Asset Swaps (With Excel Template)
Let’s take an example to understand the calculation of asset swaps in a better manner.
Let’s say the investor has provided the following set of information:
|Credit Rating of the bond||BBB|
|Frequency of Payment||Annual|
|Full Price of the bond||105%|
|Notional Principal Amount||10,00,000|
|Base Swap Rate||6.00%|
|Premium over price||0.50%|
- Calculate the quote for the asset swap
- Calculate the flow of payments if the LIBORs are as follows
Swap Asset Spread
|Fixed Coupon Spread to be paid||7.00%|
|Swap rate to be received||-6.00%|
|Swap Asset Spread||0.50%|
|Quote for Asset Swap||LIBOR + 0.50%|
|Dates||Floating Receipts||Fixed Payment||Net to be received / (paid)||Net to be received / (paid) ($)|
- The floating rates are calculated using the LIBOR + 0.50% computed above.
- The investor will pass on the fixed payments to the swap seller and receive the variable inflows per market expectations.
- He is hedged against the default on account of the bond issuer.
Who Does This?
- This is usually done by financial institutions that want to receive fixed cash inflows against their short-term commitments.
- It reduces the risk of an interest rate for financial institutions.
- Bankers profit if the return on swap (fixed) is higher than the LIBOR-based payments.
- Also, it is used by investors who want to get hedged against various risks associated with bonds.
Mechanics of Asset Swap
- The swap buyer will first purchase a bond by paying its full price. The full price of a bond means the bond’s par value plus interest accrued for the period from the last interest payment date till the current date. This interest is called accrued interest.
- The buyer will now enter a swap counter with a financial institution. It will then pass the fixed coupons to the financial institution and receive LIBOR-based floating payments against it.
- This continues until the maturity of the bond period.
- The floating rate is decided at the inception of the agreement.
Risks of Asset Swap
Here are the risks which an investor faces.
|Liquidity||The swap is not quoted elsewhere since it is over a counter transaction.|
|If the swap buyer wants to liquidate his position, he must terminate the swap at market available value. Thus, there is no readily available liquidity.|
|Default||It is the risk that the bond issuer will default on the repayment of the principal amount.|
|Mark to market||Swap assets require a margin. A change in base rate (LIBOR) may demand a change in margins. Further, changes in the bond value are unrealised gains.|
|Thus, there may be a negative mark to market value for the swap transaction with corresponding unrealized gain for the bonds.|
|Credit Spread||There is a risk that the spread of the swap may increase or shrink depending on the market expectations.|
Advantages of Asset Swaps
Some of the advantages of asset swaps are given below:
- First, it helps investors to convert their fixed income into floating income, reflecting the changes in the market rates.
- It acts as a hedge for the investor against various types of risks, such as default risk, liquidity risk, and interest rate risk.
- The financial institution receives a fixed inflow of cash for its short-term commitments. Therefore, its short-term cost of funds is minimized due to such an arrangement.
- The investor can earn a spread using the money market indices.
- Credit spreads depict the target funding cost, and it provides an estimation of the investment returns from the swap transactions.
Disadvantages of Asset Swaps
Some of the disadvantages of asset swaps are given below:
- It is complex for a layman to understand the operational mechanism. So, an educated unknown person may get fooled within the terms of the swap if he enters without the assistance of a finance expert.
- The overall structure is complex as compared to the issue of bonds or hybrid instruments.
Conclusion – Asset Swaps
Asset swap is a tool to convert the fixed inflow of money into a floating inflow. It helps ensure that the inflows are per the prevailing market rate. Also, in case of default by the bond issuer, the investor receives floating until the bond’s maturity. The investor may sell the bond in the market over the counter. The financial institution accesses the credibility of the underlying asset before entering into a contract.
This is a guide to Asset Swaps. Here we also discuss the definition and how does it work? Along with advantages and disadvantages. You may also have a look at the following articles to learn more –