By accessing foreign credit markets, credit investors can add diversity to their portfolios and take advantage of relative value opportunities. While investors can do this using the cross currency asset swap, investors concerned about the associated default contingent risk can use the perfect asset swap structure.
Introduction
Most credit investors focus solely on assets denominated in their base currency. This restricts their flexibility in two important ways. First, it limits their ability to capitalize on the possibility of improved diversification gained by accessing credit names that never issue in the investor's base currency. Second, it prevents investors from taking advantage of relative value opportunities, particularly when the foreign-denominated debt trades cheap to debt of the same issuer issued in the investors' base currency.
Cross currency asset swaps are the traditional mechanism by which credit investors transform fixed rate bonds in a foreign currency into domestic assets. They substantially reduce the currency and interest rate risk, converting the foreign asset bond into an almost pure credit play. When the asset to be swapped is denominated in a currency different from that of the investor's, it is possible to create a cross currency asset swap structure to remove almost all of the interest rate and currency risk.
Figure 2 sets out the structure of a typical cross-currency asset swap in which a euro-based investor purchases EUR100 million of the credit exposure of a dollar asset. The spot FX rate used is USD1.10. The euro-based investor therefore buys face value USD110 million of a five-year dollar asset which has a 6.75% coupon and a full price of 99.80. At the same time the investor enters into a cross currency swap with a swap counterparty where the spread payment on the euro leg of the swap is 325bp.
It is possible to formulate a mathematical relationship between the cross currency asset swap spread ASW$ and that of the dollar asset swap spread ASW$ . This is given by
where the PV01 is the present value of one basis point coupon stream to the asset maturity in the respective currency discounted on the LIBOR curve, and B¤/$ is the euro-dollar basis swap. It is clear from the definition of the PV01s that if two currencies have similar levels of interest rates, they will have similar PV01s. For example, we see that the five-year dollar PV01 is currently around 4.65 while the equivalent euro PV01 is about 4.63. So the PV01 ratio for swapping a dollar asset equates to a spread difference of less than 1bp even on a dollar asset swap spread of 200bp--not significant when compared to the basis swap or bid-offer spread.
Cross-Currency Relative Value
When swapped into the investor's base currency using equation (1), the spread levels for bonds issued by a company may trade at different levels to those of bonds issued directly by the same company in the investor's base currency. This can provide relative value opportunities for credit investors who can use cross currency asset swaps to source the bonds of an issuer denominated in other currencies where they may trade cheap on an asset swap basis. These spread dislocations between markets can be substantial and can persist for long periods of time. They exist due to different degrees of risk aversion across currencies, different levels of demand and because of differing tax and other regulations. Also, as many investors are not permitted to enter into interest rate swaps, the number of market participants who can exploit these relative value opportunities is limited.
Default Contingent Risk
If there is no default during the life of the asset swap, the swap closes out at maturity with an exchange of notionals with the investor paying dollars and receiving euros on the initial notional. However, the basic cross-currency asset swap has a default contingent interest rate and currency risk--if the asset in the asset swap defaults, the investor is left exposed to:
* the mark-to-market of the cross-currency swap which can
be positive or negative depending on how interest rates and
FX rates have moved since trade initiation, and
* the recovery paid on the foreign asset which may have a
different value when converted into domestic currency at
the spot FX rate to that paid on the same face value of
domestic asset.
In order to quantify these risks more precisely, we have used a model of interest rates and FX rates and have plotted in Figure 2 the distribution of forward swap mark-to-markets on an example on-market five-year euro-dollar swap in which the asset swap buyer is paying a fixed coupon of 6.5% on the dollar notional and receiving euro LIBOR plus a spread of 175bp. The interest rate and FX volatilities used were calibrated to the respective volatility markets.
In order to quantify the risk, we calculated a 95% confidence limit Value-at-Risk (VaR) of about 24%. This is significant, meaning that in 5% of defaults, the loss on the swap mark to market could be greater than 24% of the swap notional. It is possible to show that any loss (or gain) on the cross currency swap mark-to-market should be offset to some extent by the gain (or loss) on liquidation value of the defaulted dollar asset.
To avoid this default-contingent risk, investors who wish to buy foreign denominated assets and enter asset swaps should consider Perfect Asset Swaps. These are structured in an identical manner to a standard cross currency asset swap except for the fact that the investor has no default contingent currency or interest rate risk.
Perfect Asset Swaps
If there is no default, the structure of the perfect asset swap is equivalent to the standard cross currency asset swap with the additional features that the asset swap seller:
* Takes on the default contingent swap mark-to-market
risk, and
* Quantoes the recovery rate of the defaulted asset in the
investor's base currency.
Such a structure has featured widely in the CDO market where it has been used to immunize mixed-currency high-yield bond portfolios against currency risk in order to allow the structure to qualify for the desired rating from the rating agency.
By removing this default contingent FX and interest rate risk this perfect asset swap is a pure credit play. The cost of removing this default contingent swap mark-to-market risk and quantoing the recovery rate depends upon:
* The volatility of the FX rate.
* The credit quality of the fixed rate asset.
* The expected recovery rate of the defaulted asset.
* The details of the interest rate swap
* The shape of the LIBOR curves in both currencies
* The volatility of interest rates in both currencies
* The correlations between interest rates, FX and the
default process.
Any pricing would require a model that captured all of these effects. The cost can be amortised over the life of the trade into the spread paid on the asset swap. It is interesting to note that the cost of this structure may not be as substantial as one might expect given that the two risks--the swap mark-to-market and the quantoing of the recovery rate--are actually offsetting.
This week's Learning Curve was written by Dominic O'Kane,head of the European quantitative credit research group, and Lutz Schloegl, director in the European quantitative credit research group at Lehman Brothersin London.
