What Is an Asset Swap?

Just as the name suggests, asset swaps comprise an exchange of real assets instead of cash flows. In a way, as far as structure is concerned, an asset swap can be deemed similar to a plain vanilla swap. However, the only major difference between these two is that in the asset swap, instead of regular fixed or floating loan interest rates swapping, floating and fixed assets get exchanged.

All of the swaps are derivative contracts that allow two parties can exchange financial instruments. These instruments can be anything; however, most of the swaps only include cash flows on the Basis of the notional principal amount that both the parties agree upon.

A thing that should be noted here is that swaps cannot be traded on exchanges. And, generally, retail investors don’t participate in this type of swaps. In a way, swaps are over-the-counter contracts between financial institutes or businesses.

Understanding Asset Swap

Asset swaps, in a way, can be used to overlap the fixed interest rates with floating rates of bond coupons. In this sense, they can be used to transform the Underlying asset’s cash flow characteristics to hedge the risks of the asset, whether relevant to interest rates, credit and/or currency.

Generally, an asset swap comprises transactions wherein the investor takes the bond position and steps into an interest rate swap with the same Bank that sold him the bond. And then, the investor pays fixed but receives floating.

This approach is extensively used by banks to convert long-term fixed rates assets into Floating Rate to fulfil their short-term obligations. Another prevalent use of asset swap is to get insured against any loss arising because of credit risks, like the issuer going bankrupt or Default.

Example of an Asset Swap

Let’s take an asset swap example here. Suppose you are Investing in a bond at a dirty price of 120%. Now, you want to hedge the risk of going default by the bond issuer. Then, you may contact the bank to get an asset swap done.

The fixed coupons of the bond are 6% of the par value. And the swap rate is 5%. Now, assume that you have to pay 0.5% price premium during the lifetime of the swap. This way, the asset swap spread will be

6 – 5 – 0.5 = 0.5%

Thus, the bank will be paying you 0.5% rates during the lifetime of the swap.