Asset swap

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Asset swap is used to transform cash flow characteristics of the asset to hedge or create investment with more suitable CF characteristics. In practice, the buyer buys a bond at dirty price (including accrued interest). Then buyer agrees to pay fixed coupons to swap seller. In return buyer receives variable rate payments based on LIBOR[1]. Most often swap contracts are used to manage assets. They give you the option of managing payment streams that are created according to your preferences. For example, a company that in its assets would prefer to see paper that brings fixed interest and who managed to acquire bonds with a delightful and satisfactory interest rate is able to create the correct payment structure by means of a swap contract.

The asset swap is very important to derivatives market, as it relates cost of credit to LIBOR.

The swap transactions

The swap transaction is primarily a contract between two partners. They depend on a given market parameter, including interest rate or exchange rate. These transactions describe the principles of mutual payments. The main type of this activity is the concluded agreement, in which one of the parties covers the consequences of changes in the second parameter. In conclusion, he covers the difference resulting from the growth of certain factors. Let's give it when someone pays the sum of the interest increase of a given loan, resulting from the increase in interest rates. When a situation occurs in which a given parameter falls, a given amount is assumed, appropriate to the situation that the market initiated by the partner. For example, these may be gains that are associated with a decrease in the interest rate. The height of transfers between pages can be transformed, as well as the direction depending on the scale of the parameter changes and the direction[2].

Swaps were created in the late seventies, so you can easily guess that this is a fairly new financial instrument. The swap market is defined as the OTC market (Over the counter market), the market is characterized by high dynamics of turnover growth. His dynamics turned out to be so big that he exerted considerable influence on other markets.

The essence of the transaction

As a result of the contract, one of the parties may treat one of the market parameters as if it were permanent. Thanks to this, we can make a more accurate economic calculation, which will allow the risk of loss to be absorbed, which may result from an adverse change in the interest rate or exchange rate. The other side earns when the market has formed a given parameter at a more favorable level.

At the time when the interest rate is lower than the one set, the party that is connected with the fixed interest rate has no profits because it must balance the difference between the contracted interest rate and the existing one multiplied by the contract size.

However, if the market rate is higher, there is a chance that a fixed rate page can make a profit. Then the other partner is obliged to convey the difference between the rates. In swap transactions, another financial institution (swap dealer) mediates. The dealer has the option of entering into a contract with one of the parties and then searching for the other party. The purpose of exchanging payments is to achieve a profit by both parties and financial intimacy, which is an intermediary.

SWAP and banking operations

  • Swap transactions are exchanging sums of money between two periods, in the same currency, for example, buying euro with immediate delivery and selling them for 2 months with delivery.
  • The central bank concludes such transactions with commercial banks to manage the banking sector's liquidity.
  • Swap agreements also mean transactions that are exchangeable, for example, between two borrowers who exchange loan servicing with each other.

Generations and types

At the beginning, the swap transactions were conducted by the Central Bank in the event of tensions in the money market. Currently, they are used by commercial banks. They are divided into two generations. The most classic ones are called the first generation and include:

  • Foreign swap (FX swap, currency swap) - transfer of receivables and liabilities in different currencies, combined with a percentage transaction.
  • Interest rate swap (IRS) - contract of two parties on the exchange of periodic interest payments in a given period.
  • Cross currency interest rate swap (CIRS) - a two-currency interest rate swap transaction, i.e. exchange of equity, will combine pages in two currencies, interest payment exchanges on nominal amounts and exchange of capitals at the immediate exchange rate from the swap start date.

LIBOR

LIBOR is the main indicator by which we can get information on the progress of credit situation in the global market. It expresses the price at which the London banks (in the form of an interest rate) take with them, which count towards the first category. The level of the indicator is generated every day at 11 GMT by Thomson Rruters. LIBOR is determined for loans in ten currencies and the repayment date varies. Thanks to LIBOR, we can find use in many international and international phanic operations.

This is treated as an independent sum of money: the interest rate on credit operations can be variable over time and should represent the sum of the LIBOR size and the premium received in exchange for the risk related to the transactions. When LIBOR is at a low level it means the availability of cheap money on the financial market.

The size of the LIBOR interest rate is constantly changing depending on economic constraints.

Examples of Asset swap

  1. Fixed-for-floating asset Swap: A fixed-for-floating asset swap involves exchanging a fixed rate of interest payments for a floating rate of interest payments. This type of asset swap is often used to convert a fixed-income instrument, such as a bond, into a floating-income instrument, such as a floating-rate note.
  2. Currency Asset Swap: A currency asset swap allows investors to exchange the currency in which an asset is denominated for another currency without having to convert the underlying asset itself. This type of asset swap is often used to hedge currency risk or to gain exposure to a different currency.
  3. Equity Asset Swap: An equity asset swap involves exchanging the return on an equity asset for a predetermined fixed or floating interest rate. This type of asset swap allows investors to gain exposure to the equity market without having to purchase the underlying equity.
  4. Credit Asset Swap: A credit asset swap is a type of asset swap in which an investor swaps the return on a credit instrument, such as a bond, for a predetermined fixed or floating rate of return. This type of asset swap is often used to hedge credit risk.

Advantages of Asset swap

Asset swaps can provide a number of advantages, including:

  • The ability to convert an asset with a variable interest rate into a fixed-rate instrument, allowing for more consistent cash flows.
  • The ability to reduce the cost of borrowing, as the asset swap can be used to negotiate a lower interest rate than what would be available through traditional debt instruments.
  • Enhanced liquidity of a bond portfolio, as asset swaps can be used to trade the underlying asset without the need to liquidate the bond portfolio.
  • The potential to generate higher returns, as asset swaps can be structured in such a way that investors can benefit from any changes in the underlying asset’s price.
  • The ability to hedge risks associated with interest rate fluctuations, as the asset swap can be structured to protect against any changes in the bond’s risk profile.
  • The potential to create a more tax-efficient portfolio by structuring the asset swap in such a way that the investor can take advantage of any tax advantages associated with the underlying asset.

Limitations of Asset swap

  • Asset swaps can be complex and difficult to understand, making it difficult for investors to evaluate the risks involved in the swap.
  • Asset swaps are inherently illiquid, making them difficult to exit or unwind.
  • Asset swaps are subject to counterparty risk, as the swap agreements are only as strong as the parties involved.
  • Asset swaps are subject to regulatory risk as rules and regulations governing swaps can change, making them less attractive to investors.
  • Asset swaps can be expensive, as fees and costs can add up quickly.
  • Asset swaps can be difficult to price accurately, as there are many variables and complexities involved.

Other approaches related to Asset swap

  • Interest rate swaps: This type of swap involves two parties exchanging the difference between a fixed interest rate and a floating rate, usually based on LIBOR.
  • Currency swaps: This type of swap involves exchanging a certain amount of currency from one party to another at a predetermined rate.
  • Credit default swaps: This type of swap is used to protect against the risk of default on a borrower’s loan. The protection is usually offered by a third-party investor.
  • Equity swaps: This type of swap involves exchanging the returns of an equity for the returns of an index or another equity.

In summary, asset swaps are a type of financial derivative used to manage assets and payment streams. Other types of swaps include interest rate swaps, currency swaps, credit default swaps, and equity swaps.


Asset swap — recommended articles
Swap Ratio — Noncovered security — Equity instrument — Currency certificate — Translation Risk — Bonds in finance — Held to maturity securities — Interbank market — Funding Operations

References

Footnotes

  1. ↑ Duffie, D. (1999)
  2. ↑ David X. Li, S. (1999)

Author: Magdalena Worłowska

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