Can someone tell me why do we buy an asset swap and a CDS when the asset swap spread is greater than a credit default swap spread. I thought we were supposed to buy low and sell high
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OMG! Are you studying derivatives Pierre? don’t do this man! You promised you won’t…I was counting on that!!! Be french enough to keep your word! …er … never mind.
In the asset swap you buy a bond from a seller for cash, in return the seller pays you the interests (I). Now, you want to convert these fixed payments into a LIBOR +X entering in a fixed pay (F) interest rate swap with the broker. Assume, that you make a cool deal and fixed rate to the dealer is less then the interest you receive on the bond. In order to hedge your liability to the broker you might want consider to buy a CDS, thus shorting the credit risk from the bond seller.
You get: I + LIBOR + X
You pay: F + CDS spread
Thus, the CDS spread should be small enough for you to hedge your liabilities to the broker and staying long the floating rate.
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