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Asset Swap Spreads and Darrel Duffie on Futurization of Swaps


barnejek’s blog, This time is different. No, really! here.

If you follow me on twitter you will have noticed that lately I have been talking a lot about asset swaps (ASW). This is a pretty technical concept but I will try to be as straightforward as possible.

If you are still reading this then you probably know that in the fixed income market we have two broad groups of instruments – cash bonds and swaps. In theory, their yields (prices) should be moving more or less in a parallel fashion because they are interest rates instruments. In other words, you can bet on interest rates going lower by either buying bonds or receiving interest rate swaps (IRS). The difference between those two instruments is called the asset swap and it tends to move for the following main reasons:

  • Buying bonds requires balance sheet and IRS is an off-balance sheet instrument.

  • Buying government bonds creates exposure against the issuer (sovereign) while IRS is a contract between two counterparties (e.g. banks).

  • Supply of bonds is limited while IRS can be created out of thin air.

  • Government bonds are a stream of cash flows (coupons) while IRS is an exchange of fixed against floating rate (e.g. LIBOR).

Dominic O’Kane, Introduction To Asset Swaps, 2000, here.

An asset swap is a synthetic structure which allows an investor to swap fixed rate payments on a bond to floating rate while maintaining the origi- nal credit exposure to the fixed rate bond. The pricing of asset swaps is therefore primarily driven by the credit quality of the issuer and the size of any potential loss following default. This article gives a simple overview of the mechanics of asset swaps, explains the risks inherent in the structure and how these affect the pricing and describes some of the reasons for buy- ing and selling asset swaps.

Darrel Duffie, Bloomberg, Futurization of Swaps, here. Duffie is probably one of the leading academics in Trading EcoFin along w Andrew Lo, Merton, Scholes,  Jarrow, Longstaff, Tuckman, Avellaneda. Doubt these folks typically show up in Coursera or EDX – that’s not how they roll. OK class who going to show up for Gilbert Strang’s PDE class Black Scholes video, here? You will pretty much have Mr. T teaching Java programming for artists III long before these other guys show up for a free web lecture to 100,000 students in Latvia.

A small number of big dealers have had an effective oligopoly in the intermediation of OTC derivatives markets. According to International Swaps and Deriva- tives Association data for 2010 assembled by David Mengle, 82 percent of the notional outstanding value of OTC derivatives globally was held by the largest 14 dealers.

In the U.S., the top 5 dealers maintain 95.5 percent of the total derivatives positions held by U.S. banks and their affiliates, according to statistics provided by the Office of the Comptroller of the Currency. At least until recently, significant intermediation profits for dealers in OTC derivatives have been made possible in part by the relative opaqueness of OTC markets. Because of this, dealers did not have much incentive to encourage the futurization of swaps.

Now that Dodd-Frank will require pre-trade compe- tition and post-trade price transparency for standard- ized OTC derivatives, it will be harder to maintain those high profit margins. The writing is on the wall. Compliance costs are also up in OTC markets for dealers and other major market participants. So there is now a much greater incentive, or at least a reduced disincentive, for derivatives trading to migrate to exchanges.

Dark Markets, here.  Have not read it – seems like I should.


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