Asset Swaps and Swap Spreads: Interest Rate Strategy

21469 WordsSep 24, 201286 Pages
MORGAN STANLEY FIXED INCOME RESEARCH Morgan Stanley & Co. International Limited Giles Gale Primary Analyst +44 (0)20 7677 7121 European Interest Rate Strategy Group +44 (0)20 7677 7528 July 12, 2005 Interest Rate Products Europe Asset Swaps and Swap Spreads Interest Rate Strategy The spread between swaps and bonds can be traded in many different ways. In this note we describe asset swapping methodologies in detail with particular emphasis on calculation of spreads, risks, and tracking of trades. The spread of bond yields to swaps is also commonly used to evaluate richness and cheapness of bonds of differing maturities. In markets where the analytical power of players is ever growing,…show more content…
An asset swap is an agreement to swap the form of the stream of future cash flows or benefits generated by an asset, typically from fixed to a market based floating rate such as Libor. The buyer of a bond may prefer floating cashflows as a match for expected future liabilities, for example. They may also wish to swap a fixed coupon asset in order to reduce the interest rate risk associated with it or to ensure it better matches liabilities expected to be linked to market interest rates. Similarly, a borrower may issue a fixed coupon bond for demand reasons, but prefer floating liabilities. This is common, for example with financials. Organisation Of This Paper This note has three main sections. In the first part, we detail the mechanics of different asset swapping techniques seen in the market. In the second part, we assess the value of the information that different methodologies provide on the richness and cheapness of bonds. In the third part of the note, we explain what we view as the drivers underlying the dynamics of swap spreads. We then discuss how these factors may serve to explain the differences in swap spreads observed between markets. Finally, we quantify the roles of some of the factors, and illustrate their interrelationships in a series of simple empirical models based on US and European data. See additional important disclosures at the end of this report. 2 MORGAN STANLEY FIXED INCOME RESEARCH July 12, 2005 Asset Swaps and Swap
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