7 The Asset Swap±Credit Default
We saw in Chapter 2 that asset swaps, although pre-dating the credit derivative market, are
viewed as a form of credit derivative. They are viewed as cash market instruments. However,
because an asset swap is a structure that explicitly prices a credit-risky bond in terms of its
spread over Libor (inter-bank credit risk), it can be viewed as a means by which to price
credit derivatives. In fact, in the early days of the credit derivatives market the most
common method of pricing credit default swaps was by recourse to the asset swap spread
of the reference credit, as the credit default swap premium should (in theory) be equal to
the asset swap spread of the reference asset. Certainly we can say that the asset swap
provides an indicator of the minimum returns that would be required for specific reference
credits, as well as a mark-to-market reference. It is also a hedging tool for a CDS position.
We first consider the use of this technique, before observing how these two spread levels
known as the credit default swap basis differ in practice.
7.1 Asset swap pricing
7.1.1 Basic concept
Credit derivatives are sometimes valued using the asset-swap pricing technique. The asset-
swap market is a reasonably reliable indicator of the returns required for individual credit
exposures, and provides a mark-to-market framework for reference assets as well as a
hedging mechanism. As we saw in Chapter 2, a par asset swap typically combines the sale
of an asset such as a fixed-rate corporate bond to a counterparty, at par and with no interest
accrued, with an interest-rate swap. The coupon on the bond is paid in return for Libor, plus
a spread if necessary. This spread is the asset-swap spread, and is the price of the asset
swap. In effect, the asset swap allows market participants that pay Libor-based funding to
receive the asset-swap spread. This spread is a function of the credit risk of the underlying
bond asset, which is why it may be viewed as equivalent to the price payable on a credit
default swap written on that asset.
The generic pricing is given by:
is the asset swap spread;
is the asset spread over the benchmark;
ir is the interest-rate swap spread.
Parts of this chapter first appeared in Choudhry (2001) and Choudhry (2003).