# Asset Swaps: Understanding Fixed and Floating Asset Exchanges

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> **Definition**
>
> An asset swap is a derivative contract where two parties exchange fixed and floating assets.

## What Is an Asset Swap?

An asset swap is a [derivative](https://www.investopedia.com/terms/d/derivative.asp) contract where two parties exchange fixed and floating assets. Floating assets continually change in quantity or value. Most [swaps](https://www.investopedia.com/terms/s/swap.asp) involve cash flows based on a [notional principal amount](https://www.investopedia.com/terms/n/notionalprincipalamount.asp) and an actual asset exchange.

Swaps do not trade on exchanges, and retail investors do not generally engage in swaps. Rather, swaps are [over-the-counter](https://www.investopedia.com/terms/o/otc.asp) (OTC) contracts between businesses or financial institutions. This allows institutional buyers to hedge their exposure to interest rate risks.

### Key Takeaways

*   Asset swaps are derivative contracts where parties exchange fixed and floating assets to manage financial risks.  
    
*   These swaps are over-the-counter agreements used mainly by businesses and financial institutions, not retail investors.  
    
*   Asset swaps can be used to hedge currency, credit, or interest rate risks by overlaying fixed bond coupon rates with floating rates.  
    
*   The swap's maturity matches the asset's maturity, providing protection for the swap buyer if a default occurs.  
    
*   The asset swap spread is the difference between a bond's yield and the swap rate, measured in basis points.

## How Asset Swaps Work

Asset swaps hedge currency, credit, or interest rate risks. Asset swaps overlay the fixed interest rates of bond coupons with floating rates. An investor acquires a bond position and then enters an [interest rate swap](https://www.investopedia.com/terms/i/interestrateswap.asp) with the bank that sold them the bond.

The swap or protection buyer purchases a bond from the swap or protection seller, paying a "[dirty price](https://www.investopedia.com/terms/d/dirtyprice.asp)." This price equals the par value of the bond plus its accrued interest. The buyer enters a contract to pay the seller fixed coupon payments equal to those received from the bond. The seller agrees to give the buyer a floating rate payment based on a benchmark plus or minus a fixed [spread](https://www.investopedia.com/terms/s/spread.asp). 

The maturity of this swap is the same as the [maturity](https://www.investopedia.com/terms/m/maturity.asp) of the asset. The swap buyer is essentially buying protection and the swap seller is also selling that protection. In the event of default, the swap buyer will continue to receive payments plus or minus the spread from the swap seller.

> **Fast Fact**
>
> Banks use asset swaps to turn long-term fixed-rate assets into floating-rate ones to align with short-term liabilities.

## Understanding Asset Swap Spreads

An asset swap spread is the difference between the bond's yield and the corresponding swap rate. It represents the premium or discount the bondholder receives or pays relative to the swap rate. This spread is commonly expressed in basis points.  

*   **Bond Yield:** The discount rate where the present value of a bond's cash flows equals the bond's market price.
*   **Swap Rate:** The fixed rate in the swap contract where the value of the fixed leg equals the value of the floating leg.  
      
    

> **Important**
>
> Asset swaps generally rely on the Secured Overnight Financing Rate (SOFR), the interest rate banks use to price U.S. dollar-denominated derivatives and loans. The SOFR is based on transactions in the Treasury repurchase market, where investors offer banks overnight loans backed by their bond assets.

## Example of an Asset Swap

Suppose a business buys a bond at a dirty price of 110% and wants to hedge the risk of a default by the bond issuer. The bond's fixed coupons are 6% of the par value. The swap rate is 5%. Assume that the investor has to pay a 0.5% price premium during the swap's lifetime. The asset swap spread is 0.5% (6% - 5% - 0.5%). Hence the bank pays the business SOFR rates plus 0.5% during the swap's lifetime.

## How Do Asset Swaps Differ From Plain Vanilla Swaps?

A [plain vanilla swap](https://www.investopedia.com/terms/p/plain-vanilla-swap.asp) is the simplest in the market and is often used to hedge floating interest rate exposure. Asset swaps are similar to a plain vanilla swap with the key difference being the underlying of the swap contract.

## How Do Asset Swaps Help Prevent Credit Risk Loss?

Asset swaps can insure against loss due to [credit risk](https://www.investopedia.com/terms/c/creditrisk.asp), such as default or [bankruptcy](https://www.investopedia.com/terms/b/bankruptcy.asp), of the bond's issuer. Here, the swap buyer is also buying protection. Some asset swaps can be complicated, such as [asset-swapped convertible option transactions (ASCOT)](https://www.investopedia.com/terms/a/ascot.asp) used to separate fixed-income and equity components of a bond offering.

## What Is the Difference Between a Positive or Negative Asset Swap Spread?

If the spread is positive, the bondholder receives a premium for the bond's credit risk. If the spread is negative, the bondholder pays a premium to eliminate the bond's credit risk.

## The Bottom Line

An asset swap is a derivative contract where two parties exchange fixed and floating assets. They are traded over-the-counter by businesses or financial institutions, not retail investors. Asset swaps are used to hedge against currency, credit, or interest rate risks and involve overlaying fixed interest rates with floating rates. They convert long-term fixed-rate assets to floating-rate ones, helping banks match short-term liabilities.  

In an asset swap, the buyer buys protection that ensures continued payment in the event of a default, while the seller provides floating rate payments based on a benchmark rate plus a spread.  

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