Credit Derivatives: Trading, Investing and Risk Management, Second Edition

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Asset Swaps and Asset Swap Spread; z-Spread

Asset swap deals are of interest to us for two reasons. First, the ‘asset swap spread’ is a widely used measure of credit risk in a general sense, and is also used as an alternative to talking about the price of a credit bond. Second, the asset swap contract itself is a derivative involving credit risk and, in some versions of the contract, embeds credit risk in a non-trivial way. For further details of asset swap products the reader should consult Das (2004), or Flavell (2002).

3.1 ‘PAR-PAR’ ASSET SWAP CONTRACTS

3.1.1 Contract Description and Hedging

The contract we describe is referred to as a ‘par-par’ asset swap. The investor pays par to an asset swap desk to gain exposure to a par notional amount of a particular fixed coupon bond issued by a chosen reference name. The asset swap deal pays the investor floating payments (of LIBOR [or some other reference rate] plus the ‘asset swap spread’) until maturity or until the default of the reference name.

The investor receives the floating payments on pre-agreed dates - which may differ from the coupon payment dates and may be more frequent - and par at maturity. On default of the reference bond the investor receives a cash sum and the contract terminates. From the investor’s point of view the asset swap deal converts a fixed coupon bond into an FRN initially costing par.

3.1.2 Hedging

The asset swap trading desk hedges the asset swap deal by entering two contracts. First, the ...