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Asset Swaps are a Portfolio Imperative Today

Aug 26, 2008
In its most rudimentary form, an asset swap is an exchange of the cash flow or risk profile of one asset for another, for a given, pre-determined period of time. Assets swaps are undertaken for a variety of reasons but, fundamentally, they are driven by the investor need to improve or rationalize the character of an underlying asset (debt paper or equity) on specific terms.

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. Briefly, the opportunities afforded by asset swaps are limited only by the numerous, virtually unlimited, opportunities available in the marketplace today.

Why asset swaps today?

The subprime crisis demands that virtually every investment portfolio be scrutinized from the twin prisms of repricing and reallocation; repricing because the risks embedded in any investment instrument have multiplied in recent weeks, reallocation because the quality of an overwhelming portion of the currently outstanding debt instruments is now being questioned.

The transition in asset valuations (and related valuation techniques) could well continue through the next 12-18 months. This transition is likely to cause serious damage to investment portfolios, given that higher oil and food prices are adding to the questions surrounding the core fundamentals of the debt market. The global economy, which is in the midst of significant re-alignment, will inevitably force wider spreads and lower liquidity in the months ahead.

In brief, failure to take decisive measures to protect and, quite possibly, enhance your investment portfolio today is likely to degrade overall risk-reward profiles; a dormant portfolio is, quite simply, a disaster waiting to happen.

Furthermore, it should be pointed out, that traditional hedges like futures, forwards and options are no longer workable in the current environment; 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 convertibles; but they go beyond the scope of traditional investment vehicles by providing an extremely high degree of flexibility with respect to investment strategy, short or long term.

Significant Pointers

From the perspective of the junior markets, the most challenging asset swaps will be being influenced by the need to swap equity into debt, primarily due to the fear of renewed (and unprecedented) potential downside in hundreds of junior (growth-oriented) share listings; asset swap specialists already report a seemingly unending stream of inquiries seeking to cover downside risk in this area. The other subject of immediate relevance is the interplay between resource-based operations on one hand and debt or hybrid prices on the other. Given the founding premises of the collapse in the sub-prime market, real estate real will become another focus for asset swap traders.

Most importantly, the asset swap is a structured product. While there are standard currency and interest rate swaps which are commonly used in the asset swap segment of the capital markets, incorporating risk transfers (e.g. equity to bonds, debt-quality exchanges and commodity-linked mechanisms) into an asset swap format requires a degree of innovation and engineering.

For junior companies, the exponential rise in precious metals and energy prices has created a powerful window of opportunity in the asset swap arena. To take one particular example, there is now a growing demand, from the corporate sector, to swap out of equity or debt risk into gold and oil futures, based on production schedules. Resource-based companies must exploit this window now.


For over two decades, managements have struggled to precisely identify the relative costs between debt and equity. The lack of making that determination has been the root cause of the impairment in the hybrid marketplace, for convertible debt and warrant-driven instruments. The asset swap process needs to incorporate the relative valuations with a high degree of exactness. In fact, the recognition of the true cost of capital itself lays the foundations for asset swaps which significantly enhance investment portfolios.
About the Author
Rakesh Saxena is a pricing and risk analysis specialist in insurance and derivative products and has extensive deal making in the emerging economies. He can be reached at derivatives@shaw.ca. Home URL: http://www.quoteplatform.com
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