7 - The Asset Swap-Credit Default Swap Basis

Abstract

This chapter discusses basic concepts related to asset swap. Asset swaps, although predating the credit derivative market, are viewed as a form of credit derivatives. They are viewed as cash market instruments. An asset swap can be viewed as a means to price credit derivatives because it is a structure that explicitly prices a credit-risky bond in terms of its spread over Libor (interbank credit risk). During the early days of the credit derivative market, the most common method of pricing credit-default swap (CDS) was that the premium should be equal to the asset swap spread of the reference asset. The asset swap provides an indicator of the minimum returns that would be required for specific reference credits as well as a market-to-market reference. The asset swap is also a hedging tool for a CDS position. The chapter discusses how the two spread levels known as the credit-default swap basis differ in practice. The chapter illustrates the concept of credit-default swap using Bloomberg.