Asset Swaps

EUROPEAN FIXED INCOME RESEARCH

Analytical Research Series

INTRODUCTION TO ASSET SWAPS

Dominic O’Kane

January 2000

Lehman Brothers International (Europe)

Pub Code 403

Analytical Research Series

Summary

January 2000

An asset swap is a synthetic structure which allows an investor to swap

fixed rate payments on a bond to floating rate while maintaining the original credit exposure to the fixed rate bond. The pricing of asset swaps is

therefore primarily driven by the credit quality of the issuer and the size of

any potential loss following default. This article gives a simple overview of

the mechanics of asset swaps, explains the risks inherent in the structure

and how these affect the pricing and describes some of the reasons for buying and selling asset swaps.

Dominic O’Kane

dokane@lehman.com

+44 –(207) 260 2628

Acknowledgements

2

The author would like to thank Mark Ames, Jamil Baz, Robert Campbell,

Ugo Calcagnini and Stephane Vanadia for their suggestions and comments.

Lehman Brothers International (Europe)

Analytical Research Series

Introduction

January 2000

An asset swap enables an investor to buy a fixed rate bond and then hedge

out the interest rate risk by swapping the fixed payments to floating. In

doing so the investor retains the credit risk to the fixed-rate bond and earns

a corresponding return. The asset swap market was born along with the

swap market in the early 1990s. It continues to be most widely used by

banks which use asset swaps to convert their long-term fixed rate assets to

floating rate in order to match their short-term liabilities (depositor accounts).

There are several variations on the asset swap structure with the most widely

traded being the par asset swap. Other types include the market asset swap

and the cross-currency asset swap. We begin by focussing on the most standard: the par asset swap.

Mechanics of a par

asset swap

A par asset swap is really two...