Asset swap arbitrage

Can someone explain asset swap arbitrage? Why do you buy and asset swap(buy bond and get into a pay fixed rate swap) and then buy a credit protection? Why do you do this? You already buy the bond with a pay fixed rate swap, which hedge you from increase of interest rate. But why do you buy a credit protection?

Because you still have the credit risk, i.e. the bond issuer may default. By buying protection you win de assetswap spread (minus the protection cost) incurring no risks (free money = arbritrage apportunity).

Hope this helps

Can you elaborate a bit on “by buying protection, you win the asset swap spread” part? You would only get paid if the bond defaults right? You are actually paying money out of pockets

Check out this video. Makes this stuff very simple to understand.

FYI: For some reason it starts 18 seconds into the video… don’t know what’s up with that.

It is just like buying an insurance for your bond, in case the bond issuer defaults (credit risk only does not covers interest rate risk) the bond holder gets paid from protection seller. Hope this helps

So imagine you buy a corporate bond with 10 years to matutiry and an annual 10% coupon. At the same time you enter into and annual IRS paying a fixed rate of 2%.

So overall on each payment date you receive 10% from the bond you pay 2% from the fixed leg of the IRS and you receive the floating rate (L). So adding it up you receive L + 8% every year. ( 8% is the asset swap spread).

This sounds good, but its not a free lunch since there is still a chance that the bond defaults in the future. This would causes big losses on your portfolio.

Now suppose you buy credit protection on the bond issuer by entering into a CDS where you annually pay a 6% fee, (think of it as insurance cost that you pay every year).

So if the bond never defaults, you would recieve L + 8% -6% = L + 2% every year! If the bond Defaults, the CDS would pay you the notional of the bond, just like if you had never bought the bond. So, overall you are vitually not facing any risks*** and receiving a nice L+2% payment every year. This “free” money is the “Assetswap arbtitrage”.

Hope this helped!

***Note: there is actually one risk still… If the bond defaults, after getting paid by the CDS, you would still have the initial IRS where you were paying fixed rate.

Thank you thank you! Throwing numbers in make a Lot sense

What if the reverse is true (CDS> Asset Swap Spread). How would you re-create an arbitrage opportunity? Do you create an Arbitrage by shorting the bond (assuming the market is liquid enough for this to be reasonably possible) and go long the CDS (sell credit protection)?

Maybe I’m just getting turned around, but if you do the exact opposite of the above arbitrage opportunity (long the bond, payer swap, and buy credit protection (short CDS)) by also taking the opposite position in the swap (Fixed Receiver), you will always owe a LIBOR payment. This payment would prevent this position from being an Arbitrage opportunity, correct?

Also remeber that you are Funding this entire strategy by borrowing at LIBOR. so you are earning 2% free. not L+2%. but good job explaining