Unlike interest rate swaps and basis rate swaps discussed earlier, in which cash flows of debt obligation were changed, asset swaps are used to change the characteristics of an asset. For example, an investor with a ten year fixed Japanese yen bond may decide to enter into a currency swap to change his investment income into US dollar. The investor may feel that the Japanese yen will lose its value against the US dollar and would like to change his income into US dollar. Assume the current five year swap rate for US$ versus Japanese Yen to be 6.45-6.50%. The coupon rate of the investor’s bond is 7.00% and the bond has five years remaining. The investor can exchange his 50 bps Japanese Yen payments at the spot market as an extra income above LIBOR or have the dealer manage that risk as well. At the maturity date, the investor can make the principal exchange with the proceeds of the bond. In this case, the investor incurs risks from both the bond and the dealer, and the dealer incurs risks from the investor and the other counter-party. Furthermore, the investor is responsible for managing both, the bond and the swap. The investor can terminate either position independently.
Asset swaps are not only used by investors to change the characteristics of their investments, but also by banks to create synthetic investment packages for their clients. For example, bank purchases a bond, which can be converted into a more desirable asset. Then the bank arranges a currency swap with the purchased bond and puts together an investment package. The bank then sells the ownership to an investor, but holds the legal rights to the bond interest payments to insure the flow of swap payments. In this package, the dealer incurs risk from the bond and the swap counter party, and not from the investor. However, the investor still faces risks from both the bond and the dealer. If the investor wishes to dispose of his investment, he can approach the dealer to see if the dealer will repurchase it.