5 - Asset swaps

Abstract

Asset swaps are a common form of derivative contract written on fixed-rate debt instruments. The end result of an asset swap is to separate the credit and interest rate risks embedded in the fixed-rate instrument. Effectively, one of the parties in an asset swap transfers the interest rate risk in a fixed-rate note or loan to the other party, retaining only the credit risk component. There are several similarities between the mechanics of an asset swap and that of an interest rate swap. As with an interest rate swap, an asset swap is an agreement between two parties to exchange fixed and variable interest rate payments over a predetermined period of time, where the interest rate payments are based on a notional amount specified in the contract. However, unlike the vanilla interest rate swap where the variable rate is London Interbank Offered Rate (LIBOR) flat and the fixed rate is determined by market forces when the contract is agreed upon, the fixed rate in an asset swap is typically set equal to the coupon rate of an underlying fixed-rate corporate bond or loan, with the spread over LIBOR adjusting to market conditions at the time of inception of the asset swap.