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Asset Swaps open huge capital market window

Jun 4, 2008
The economic and financial impact of the collapse in the sub-prime debt market has already been widely publicized. However, the average market participant, or potential participant, is unaware of the fact that the deterioration of mortgage-based securities has resulted in complete chaos in the equity and debt pricing sector. More specifically, the relationship between valuations and risk spreads is being thoroughly redefined.

Issuers of securities, as a consequence, must boldly confront the new challenge: which assets are over-priced and which ones are under-priced. On a related note, given the unprecedented volatility, what methodology should be employed to adjust a portfolio?

The answer lies in asset swaps, which qualify as perhaps the most potent instrument to tackle the complexities thrown up in recent months.

In its most rudimentary form, an asset swap is an exchange of the cash flow or risk profile of one asset for another, over a given period of time. Assets swaps are undertaken for a variety of reasons but, fundamentally, they are driven by an investor's need to improve or rationalize the character of an underlying asset (shares or bonds) within the context of specific market conditions.

For example, an investor might desire to switch from a floating interest rate profile into a fixed rate interest stream for a period of two years. Another investor might want to exchange a Euro risk for Yen for five years. Or, an investor might consider that the time is appropriate to switch from equity volatility to relatively stable debt paper. In the briefest of terms, the opportunities afforded by asset swaps, and associated credit enhancements, are limited only by a participant's ability to comprehensively identify the scope of both the risk and the upside inherent in a particular business model.

Issuers need to realize that traditional hedges like futures, forwards and options are no longer workable; either the costs are prohibitive, or hedge contracts are simply not on offer pursuant to the dramatic market shifts in recent weeks. An asset swap, as a consequence, is the only instrument which fills the void; asset swap structures are undeniably based on shares, bonds or hybrids; but they go beyond the scope of traditional investment vehicles by providing an extremely high degree of flexibility with respect to investment strategy, over the short or longer term. Moreover, asset swaps capture the ability of participants to deliver commodities and precious metals in return for risk insurance or credit enhancements. In certain instances, dormant real estate or stock inventories may also enter the pricing equation. From the perspective of the emerging markets or junior listings in the established exchanges, asset swaps will now be influenced by the need to swap equity into debt, primarily due to the fear of renewed potential downside evident in hundreds of share listings; asset swap specialists report a seemingly unending stream of inquiries seeking to cover downside scenarios.

Despite its innovative capabilities, the asset swap is not by itself is not a new financial instrument. Over the previous two decades, derivative traders caused the volumes transacted in assets swaps to increase exponentially. What is new, nevertheless, is the foreseeable transition of the asset swap matrix, from a world dominated by professional or sophisticated market players to an era where an entire series of non-institutional investors will demand a shift in their risk-reward profiles.
About the Author
Authored by Rakesh Saxena, a pricing specialist in insurance. Over 35 years experience in the international capital markets, extensive deal making experience in emerging economies. He can be reached at derivatives@shaw.ca URL: www.quoteplatform.com
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