F EB RUA RY 2 00 6
ASS ET SW APS
Gianluca Gianluc a Sal Salford ford
[email protected] +44 207 325 4334 European Fixed Income Strategy
L A I T N E D I F O C D N A E T A V I R P
Agenda
Basic concepts
Definition
Why asset swap a bond
Drivers of swap spread
Types of asset swaps
Optical
Maturity matched
Par/Par
True
Numerical example
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Basic concepts: definition
An asset swap is a transaction that combines
an interest rate security (usually fixed coupon)
an interest rate swap (sometimes a cross currency swap)
into a Libor +/- X spread package where X is called swap spread
The swap spread can be approximated by the spread between the IRR of the instrument and the swap rate for the same maturity
Asset swap package
Example: Euro area interest rate curves In %, maturity on x-axis 3.7
bond
Germany govt Italy govt
3.5
EUR swap
+ 3.3
IRS 3.1 2.9
=
2.7
Libor +/- X asset swap
2.5 1
2
3
4
5
6
7
8
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Basic concepts: why asset swap a bond
Every bond’s yield incorporates a credit and liquidity premium unique to the bond
Asset swap structures enable to isolate the credit and liquidity component
Use asset swaps to avoid unwanted duration and curve risk in relative value trading and to take macro views
Swap spread curve of high rates EMU countries In bp Austria Germany Portugal
Belgium Greece Spain
Finland Italy
France Netherlands
-10 -11 cheap
-12 -13 -14 -15 -16 -17 -18 -19
expensive
-20 Jan-07
May-08
Sep-09
Feb-11
Jun-12
Nov-13
Mar-15
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Drivers of swap spreads
Government budget deficit (most important) -> bond issuance and perceived credit quality
Risk and liquidity preferences
Shape of the yield curve
Credit conditions
Level of yields
Bank stock index
Technical factors (market flows)
mortgage market participants
flight to quality
corporate swapping activity
6M moving average of 10-year US swap spreads (bp) versus budget deficit/surplus ($bn) surplus; $bn
spread; bp
300 200
100
surplus projection
80
100
60
0 swap spread
-100
40
-200 1994
20 1996
1998
2000
2002
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Types of asset swap: 1. optical
The simplest type of swap spread
It packages the bond with a liquid vanilla swap (e.g. 10y benchmark with 10-year swap)
Notional of the swap adjusted to hedge the duration risk on the bond
No upfront payment on the swap
Cash flow mismatch, coupon rate <> IRS fixed rate
Used especially in the UK market
Advantages
Liquidity
Disadvantages
Curve and convexity risk
Bond cash flows
IRS flows
Coupon rate 100
Libor
Duration adjusted notional
Dirty Price
IRS fixed rate
Duration adjusted notional
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Types of asset swap: 2. maturity-matched
The simplest type of swap spread
It packages a bond with a swap with the same maturity date
Notional of the swap adjusted to hedge the duration risk on the bond
Cash flow mismatch, coupon rate <> IRS fixed rate
Traded at lot in €
Advantages
Completely eliminates duration and curve exposure
Transparency: easy to price
Disadvantages
Convexity risk remains, especially relevant for bonds way off par
Bond cash flows
IRS flows
Coupon rate 100
Dirty Price
Libor
Duration adjusted notional
Initial stub
IRS fixed rate
Duration adjusted notional
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Types of asset swap: 3. par/par
Addresses the problem of cash flow mismatch
It packages a bond with a swap structure with exactly the same fixed cash flows as the bond; the floating cash flows are Libor +/- X
The package trades at 100 and 100 is paid at maturity
Roughly 20% of the volumes in €
Advantages
Leaves no duration or curve risk
Disadvantages
It assumes cash flows are borrowed/invested at Libor
Bond cash flows
IRS flows
Coupon rate 100
Dirty price
Libor +/- X
100
Initial stub Dirty Price 100
Coupon rate
100
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Types of asset swap: 4. true
Addresses the problem of cash flow mismatch
It packages a bond with a swap structure with exactly the same fixed cash flows as the bond; the floating cash flows are Libor +/- X
The package trades at the dirty price and the dirty price is paid at maturity
Rarely traded in €
Advantages
Leaves no duration or curve risk
Disadvantages
It assumes cash flows are borrowed/invested at Libor
Bond cash flows
IRS flows
Coupon rate Libor +/- X
100
Dirty price
100
Initial stub Dirty Price 100
Coupon rate
100
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Numerical example: par/par asset swap
Asset swap a 5.5 year 5% coupon bond trading at a clean price of 108.97
Need accrued interest (3.19) to calculate dirty price (112.16)
Need zero rate curve derived from swap curve
0.5 year 1 year 1.5 year 2 year 2.5 year 3 year 3.5 year 4 year 4.5 year 5 year 5.5 year
2.71% 2.91% 3.01% 3.09% 3.15% 3.20% 3.23% 3.28% 3.30% 3.34% 3.40%
IRS flows Dirty price
Libor +/- X 100
Initial stub 100
Coupon rate
100
PV of swap = -112.16 + 100 + 5/(1.0271)^0.5 + 5/(1.0301)^1.5 + 5/(1.0315)^2.5 + 5/(1.0323)^3.5 + 5/(1.0330)^4.5 + 105/(1.034)^5.5 = 98.34 -1.66 = 98.34 - 100 to be amortised in equal (x) payments over the floating libor payments -1.66 = x/(1.0271)^0.5 + x/(1.0291)^1 + x/(1.0301)^1.5 + x/(1.0309)^2 + x/(1.0315)^2.5 + x/(1.0320)^3 + x/(1.0323)^3.5 + x/(1.0328)^4 + x/(1.0330)^4.5 + x/(1.0334)^5 + x/(1.034)^5.5 x = -1.66/10.0096 = -0.166 Libor spread = -0.166 * 2 * 360/365 (to change the rate from bond basis to MMKT basis) = -32.7bp
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