Asset-swap spread
Asset-swap - recognized as a combination of an interest rate swap, (an agreement of two parties, which states that both of them decide on exchanging sequence of interest payments) [1] and a cash bond. The objective of this consolidation is to alter the interest-rate basis of the mentioned bond. The consequence of this, leaves the bondholder paying a fixed coupon, and receiving a floating coupon (a spread over LIBOR - the London Interbank Offered Rate, which serves as a globally acceppted key benchmark). This coupon is referred to as the asset-swap spread, a function of the credit risk of the bond over, as well as the above interbank credit risk. It's value consists of the difference between a bond's market price and par, along with, the difference between a bond coupon and swap fixed rate [2].
Spread types
There are considered to be four types of spreads:
- Yield spread - this type of spread focuses on the difference between yields on divergant debt instruments of changeable maturities, credit ratings and risk. It is calculated through the deduction of the yield of one instrument from another one.
- Bid-ask spread - this type of spread focuses on the difference between the maximum price at which a buyer is willing to purchase an asset and the minimum price at which a marketer is willing to sell it.
- Option-adjusted spread - this type of spread focuses on the assessment of the spread of a fixed-income security rate and a rate of return considered to be risk-free, which is altered to take into concideration an embedded preference.
- Z-spread - this is the constant spread, which makes the cost of a security the same as the current value of its cash flows, when summed up with the yield, at every point on the spot rate Treasury curve where the cash flow is collected.
The asset-swap spread is an example of the yield spread classification.
Credit Default Swap
The Credit Default Swap also, known as the CDS, consists of an OTC (over-the-counter) transaction between two parties, where the protection of the purchaser, brings in a stream of coupon payment to the marketer's protection, till an earlier state of maturity, or entity default to counterbalance a default contingent fee. Such contracts can be settled by cash, when the buyer's security receives from the marketer's protection the cash amount of par less restoration.
When subtracting the CDS spread and asset-swap spread (also known as ASW) one is left with a so-called CDS-Bond basis. It's purpose is to indicate the relative value of the relation between Credit Default Swap and cash bonds. Once the CDS spread value turns out to be higher than the ASW, the basis is considered to be positive, and therefore means that the Credit Default Swap is considered as more attractive, than the cash bond[3].
Examples of Asset-swap spread
- Asset-swap spread is the difference between the yields on a fixed-rate bond and a floating rate bond of similar maturity, credit quality, and other characteristics. The two bonds are exchanged for each other in a swap transaction, with the floating-rate bond providing a fixed coupon payment and the fixed-rate bond providing a floating coupon payment. The asset-swap spread is an indication of the relative value of the two bonds.
- An example of an asset-swap spread is the difference between the yield on a 10-year US Treasury bond and the yield on an exchange-traded fund (ETF) that tracks the Barclays US Aggregate Bond Index. If the 10-year US Treasury yields 4.00%, and the ETF yields 3.50%, then the asset-swap spread is 0.50%. This indicates that the 10-year US Treasury bond is more valuable than the ETF because it provides a higher yield.
Advantages of Asset-swap spread
An Asset-swap spread is a combination of an interest rate swap, which can offer numerous advantages for both parties involved. The following are the main advantages of an asset-swap spread:
- It allows for the exchange of interest payments between two parties at different rates, which can be beneficial for both parties.
- It allows for the exchange of different asset classes, such as fixed income and equity, while still allowing both parties to benefit from the transaction.
- It can be used to hedge against any potential losses in one asset class, while still allowing for gains in the other.
- It can be used to diversify portfolios and reduce risk by reducing exposure to any one particular asset class.
- It can be used to gain exposure to certain markets or sectors, while minimizing the risk associated with those investments.
Limitations of Asset-swap spread
Asset-swap spread is a financial tool used to compare the yield of a fixed-income security to a benchmark rate. However, it has certain limitations that should be taken into account:
- Asset-swap spreads are not always reliable, as the benchmark rate used for comparison is not always the same.
- This spread does not take into account the creditworthiness of the issuer, which may be an issue when pricing securities.
- Asset-swap spreads are not always a good indicator of the creditworthiness of a security as they do not take into account factors such as liquidity, maturity, and seniority.
- Asset-swap spreads are affected by market conditions and can be volatile, making it difficult to accurately predict their value.
- Asset-swap spreads can be affected by changes in interest rates, making them unreliable for long-term investments.
Asset-swap spread is a measure of the difference between the fixed rate of a bond and the floating rate of a corresponding interest rate swap. There are several other approaches related to asset-swap spread, such as:
- Swap spread - which is the difference between the fixed rate of a bond and the fixed rate of a corresponding swap.
- Spread duration - which is the sensitivity of the asset-swap spread to changes in the yield curve.
- Z-spread - which is a measure of the spread of a bond's yield over a benchmark yield curve.
- Option-adjusted spread - which is a measure of the spread of a bond's yield over a yield curve adjusted for the impact of embedded options.
In summary, asset-swap spread is a measure of the difference between the fixed rate of a bond and the floating rate of a corresponding interest rate swap and there are several other approaches related to it such as swap spread, spread duration, Z-spread and option-adjusted spread.
Footnotes
| Asset-swap spread — recommended articles |
| Interest rate differential — Running yield — Held to maturity securities — Embedded derivative — Incremental borrowing rate — Interest Rate Collar — Basket Option — Forward points — Asset swap |
References
- Choudhry M., (2005) Understanding the Z-Spread Learning Curve, September 2005, p.1
- Marina P., (2014)Interest Rate SwapsEconomic Analysis, vol. 47, p. 69
- Zhou R., (2008) Bond Implied CDS Spread and CDS-Bond Basis September 2008, p. 1-2
Author: Marta Marzec
