on 23-Nov-2014 (Sun)

Swap spreads generall y refer to spreads that must be applied to swaps to make them in some way ‘equivalent’ to a bond.

Government bonds and bonds of ver y good credit issuers, such as agencies and supras – especially shorter issues, trade at negative spreads to swaps.

A ‘widening’ of swap spreads for high quality bonds that trade at negative swap spreads, refers to a richening of the bond (a decline in bond yield compared to swaps).

In the US, Treasury spreads are normally quoted as positive numbers as swaps used to be quoted as spreads over Treasuries.

A ‘widening’ of swap spreads for lower quality bonds that trade at positive swap spreads, refers to a pooring of the bond (a raise in bond yield compared to swaps).

In Europe, governments are normally quoted as negative numbers, consistent with the spreads arising from Par/Par transactions, although government spreads are frequently referred to as positive for convenience.

A long asset swap position or a long s wap spread position refers to owning a bond agains t a hedge in swaps.

The simplest way for an investor to achieve long asset swap position (yield-yield type) is by buying a bond and paying fixed on a swap to the same maturity.

The yield/yield asset swap trade is duration weighted so that, to the first order of approximation, the yield/yield asset swapper is exposed only to the spread between the swap rate and the bond yield and not to market direction.

The yield/yield asset swap transaction transaction (buy bond and pay fixed on a swap) gives rise to a trade on the yield/yield spread, which is defined as the yield of the bond less the swap rate of a matched maturity swap.

The yield/yield asset swap spread investor makes money as the spread widens since the bond yield falls relative to the swap rate.

Most short term (less than three to six months) views on governments versus the swaps curve are expressed as yield/yield asset swap spread because of simplicity of the methodology.

In yield/yield asset swap, cash flows are not matched, so carry needs to be calculated on both legs

In yield/yield asset swap, the trade is duration hedged, but not convexity hedged.

an on the run security or contract is the most recently issued, and hence most liquid, of a periodically issued security. On the run securities are generally more liquid and trade at a premium to other securities. Other, older issues are referred to as off the run securities, and trade at a discount to on the run securities.

United States Treasury securities have periodic auctions; the treasury of a given tenor, say 30 years, which has most recently been auctioned is the on-the-run security, while all older treasuries of that tenor are off-the-run.

If the yield curve steepens, we would expect the yield to rise further on the low coupon bond than on the high coupon bond

selling low-coupon bond and buying the high coupon bond in duration-neutral amounts will l eave us with a steepening exposure in much the same way as if we were to buy an 8- year bond and sell a 10-year bond

In an upward sloping yield-curve environment, a high coupo n bond normally has a lower modified duration than a low coupon bond.

For an investor, a par/par asset-swapped bond is like a floating rate bond, whose only net cash flows are the floating receipts, which are based on a constant spread to Libor.

The par/par methodology therefore allows an investor to be exposed only to the idiosyncrasies of the bond issuer rather than taking interest rate risk - when you receive LIBOR based cashflows rather than fixed cashflows, there is no interest rate risk. (There is a small residual interest rate risk due to the difference between the discount factors based on the government curve and those based on the swaps curve.)

the par/par asset-swap is particularly popular in credit, for investors who want to take a view on a credit, but not interest rate risk.

In case of par/par asset swap, the investor (asset- swap buyer) buys a bond from an asset swap seller for par rather than the full price. The investor then pays fixed on a swap to the maturity of the bond at a rate equal to the coupon of the bond, and receives the Libor rate less (in the case of most governments) a spread. All fixed cash flows are timed to coincide and net off.

The spread is calculated such that the present value of the swap equals the difference between par and the price of the bond in the market. The dealer is thus compensated for selling the bond at a discount or premium to its market value.

In par/par asset swap, the bond is sold for par. The swap dealer (often the same person as the bond seller) ‘lends’ the buyer by P-100, where P is the full market price of the bond.

In par/par asset swap, the coupons received by the buyer are netted off against matching fixed payments to the seller on a swap for the life of the bond.

In par/par asset swap, the buyer’s receipts on the floating leg of the swap are adjusted by a fixed spread such that the present value of the swap equals the upfront implicit loan of P-100

if we par/par s wap a bond at a spread of -40 bp ( we receive floating less 40 bp) and this spread moves to -35 bp, we can unwind the position by paying on a swap of the same notional and pay floating less 35 bp to lock in a loss of 5 bp running. the upfront payment in the second swap makes us able to sell the original bond (from first transaction) at 100, exactly the price we paid for it in the first place. We got rid of the bond and we are left with 2 swaps in opposite direction, netting at -5bp fixed on every payment.

One problem with the par/par asset swap methodology is that the trade is not duration hedged.

Par/par asset swap not being duration-hedged means that the P&L will vary with outright market level, i.e., the par /par spread is directional.

The exposure to outright market level for par/par asset swap is bullish.

Par/par asset swap depends on the dirty price of the bond, as can be seen simply from its formula.

The most important complication of par/par asset swap is the large upfront payment which requires funding considerations.

Because in par/par asset swap, the swap and the sale of the bond are not independent transactions, to model the spread fairly, we need to understand the financing cost of the large upfront payment.

In par/par asset swap funding of the upfront payment will depend on the collateral agreements in place with each counterparty.

In par/par asset swap, the distortion due to an inappropriate assumption on the funding can be very substantial where a bond trades far from par.

In par/par asset swap, the interest rate implicit on the loan of P-100 is Libor since it is repaid via a swap (for which the discount curve is Libor) which is not always an appropriate rate.

Because of the complicated nature of a par asset swap, particularly because of the need to collateralise a potentially large off market swap and because the trade is directional (not duration neutral), we believe it is unlikely that an investor would swap a bond using this methodology in order to speculate on short term swap-spread movements.

To help address the problems created by collateralisation for a par/par swap, the market value accrued or MVA technique can be used

The MVA method is very similar to the par/par method, but the difference between par and the dirty price of the bond is exchanged at maturity rather than at settlement and the floating notional is equal to the dirty price of the bond.

The result of using MVA asset swap as opposed to par/par is that the counterparty exposure is switched from the seller taking the exposure to the buyer taking the exposure - the buyer will get 100 for bond redemption and, given that the swap was on full dirty price of a bond, he will get P-100 from the swap dealer (so the buyer waits for money back, taking the exposure).

in MVA asset swap the exposure starts low and builds over time rather than starting high and reducing like in par/par asset swap

A par/par s wap creates a collateral probl em i mmediately as the s wap starts off-market and the present value declines ov er the life of the agreement. In an MVA swap, however, counterparty exposure is expected to accrue over the l ife of the swap until it is discharged with the payment of the fee at termination of the contract.

MVA delays counterparty risk and this can reduce bid-offer spreads.

The present value of the payment made to bring the bond to par in MVA asset swap is also smaller than in par/par asset swap because it occurs in the future. This means that the swap does not need to be as far off par as in the par/par methodology and the problems caused by collateralisation of a large loan are reduced.

The MVA methodology is, however, much less common than the par/par asset swap for government bonds

In MVA asset swap, the bond is sold at the market value, P.

In MVA asset swap, the coupons received by the buyer are cancelled by matching fixed payments to the seller on a swap for the life of the bond

In MVA asset swap, the buyer’s receipts on the floating leg of the swap, which is based on a notional amount equal to the dirty price of the bond, are adjusted by a fixed spread such th at the future value of the swap equals the excess paid over par, P-100

In MVA asset swap, the investor receives P-100 from the dealer at the maturity of the swap

The MVA swap does reduce the problems with collateralisation in one important respect. The off-market swap must be worth the same as the present value of the difference between the bond’s price and par paid at the maturity of the bond. As a consequence, the ‘loan’ will be for a smaller amount and the s wap spread will be smaller (if the bond trades above par).

The performance of an MVA transaction is difficult to monitor because the notional of the swap on which the transaction is based changes daily as the dir ty price of the bond changes.

Daily changes of MVA asset swap spread (because dirty price of a bond changes) means that unlike the par/par transaction, the MVA spread on one day is not an indication of the spread at which an investor can unwind a previous MVA transaction.

Unlike the par/par asset swap, in MVA asset swap, the repo and floating notional of the swap are both on the same amount