Asset Swap


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Asset Swap Valuation


1. Asset Swap Introduction

An asset swap is a financial contract in which a stream of coupons of an asset are swapped for a stream of cash flows that pay a reference index plus a spread or a fixed rate. The Asset can be a bond, loan, or bond index.


An asset swap has two legs: an asset leg and a floating leg. The asset leg is based on the cash flows of a bond. Thus it bears the credit risk as the bond might default. In other words, pricing asset swap should take credit risk into account.


Investors are compensated for credit risk by receiving an extra spread. The asset swap spreads depends on the credit ratings of the underlying bonds and can be used to extract default probabilities from bond prices.


What is the difference between an asset swap on bond and a total return swap on bond? The asset leg of an asset swap depends on the coupons of the bond only, while the asset leg of a total return swap is based on both the coupons and the price change of the bond. The floating legs of them, however, are very similar except different spreads.


What is the difference between an asset swap on bond and an interest rate swap? The asset leg of an asset swap depends on the fixed rate coupons of a bond, while the fixed leg of an interest rate swap has a constant interest rate. The asset leg could default, whereas the fixed leg of the interest rate swap is risk-free.


2. Asset Swap Valuation

All coupons and other distributions (including notional repayments) received from the bond issuer are passed through to the counterparty with a lag (several business or calendar days) or at the next reset day.


It is a good practice for pricing an asset swap by accounting for the possible termination of cash flows if the reference asset defaults or is called.