The Asset Swap—Credit Default Swap Basis I: The Asset Swap Pricing of Credit Default Swaps1


As discussed in Chapter 2, asset swaps, although pre-dating the credit derivative market, are viewed as a form of credit derivative. They are 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 (CDS) was by recourse to the asset swap spread of the reference credit, as the CDS premium should (in theory) be equal to the asset swap spread of the reference asset. Therefore 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 in theory a hedging tool for a CDS position.

We first consider the use of this technique, before observing how these two spread levels differ. The next chapter will look in detail at the factors that cause this difference in spread, which is known as the credit default swap basis.


Basic Concept

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 ...

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