How Bond Premiums and Discounts Affect Asset Swap Spreads

Summary

The document explains an asset swap spread as two components for an investor holding a fixed coupon bond and swapping that coupon for floating Libor plus a spread. The first component is the bond coupon minus the swap rate. The second reflects the bond’s price relative to par, spread over the swap’s term: a premium creates a negative adjustment, while a discount creates a positive one.

Its example uses a ten-year bond priced at 103 with a 5.5% coupon and a 5% swap rate, then illustrates combining the coupon differential with a negative premium adjustment. The discussion raises the intuitive question of why the direction changes with price. It provides a basic decomposition rather than a full valuation or derivation, and the stated adjustment is approximate; actual asset swap pricing depends on details such as cash flows, conventions, and discounting.

Key ideas

• An asset swap spread combines the bond coupon’s excess over the swap rate with a price adjustment.
• A bond trading above par contributes a negative adjustment because the premium is amortized over the swap term.
• A bond trading below par contributes a positive adjustment because the discount is recovered through the spread.
• The example illustrates the components but does not derive a full asset swap valuation.

Tags

# Asset swap spread components


# Asset swap spread components












Assume that an investor holds a bond and enters into an asset swap with a bank in which the investor pays the fixed coupon and receives Libor + spread

and the following data: 10y bond price 103, bond cpn 5.5%, 10y IRS rate 5%

The asset swap spread has 2 components:

- The excess value of the bond coupon over the swap rate is paid to the investor (only this if bond trades at par) 5.5 - 5.0 = 0.5%

- The difference between the bond price and par value is spread over the term of the swap, given the bond trades above par it will be some negative number and will be paid by the investor to the bank say -0.1%

total asset swap spread = 0.5 - 0.1 = 4.9%

can you please explain, in the simplest possibile way, why if the bond trades above par the investor pays the second component to the bank and if it would trade below par the opposite applies?

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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.