Asset Swap
Candlefocus EditorThe protection seller receives cash flows from the bond and exchanges them for a pre-calculated asset swap spread. The asset swap spread is determined by the overnight rate plus (or sometimes minus) a predetermined spread. This protection seller is essentially paid for taking on the risks associated with the bond. This cash flow component of the asset swap ensures that the exchanges adhere to the conventions of the market.
The second component of the asset swap involves the swap buyer. They buy the bond previously held by the protection seller and use it to hedge their risks. They offer a premium in return for the bond, which can appear in the form of a swap spread or collateral.
Asset swaps are used mainly by financial institutions and corporations. Asset swaps can be used, for example, to replace fixed-rate loans with variable-rate loans, thereby allowing the borrower to benefit from any possible surge in the market rate. Asset swaps can also be used to lower the risk associated with investments in a particular security, currency or commodity.
In conclusion, asset swaps are financial transactions used to lower risk and modify the cash flow characteristics of certain financial instruments. Through asset swaps, both parties involved exchange an asset that has undesirable cash flow characteristics for one with more favorable characteristics. This transaction is beneficial to both parties, as the risk-hedging swap buyer pays a premium while the protection seller earns income through the asset swap spread, which makes them whole against the market rate.