Before we explore the Asset Swap (ASW), let’s take one step back and understand this financial instrument known as Interest Rate Swap (IRS).
What is an Interest Rate Swap?
An Interest Rate Swap is a financial derivative instrument in which two parties agree to exchange interest rate cash-flow, based on a specified notional amount from a fixed rate to a floating rate (or vice versa).
The diagram below demonstrates the structure of an IRS deal.
With this in mind, one could use Interest Rate Swap to “transform” one Asset to another or a Liability to a different one. For example, an owner of a straight Bond could use an Interest Rate Swap to alter his/her asset to a synthetic Floating Rate Notes. This is a simple illustration of Asset Swap deal.
Likewise, a company that borrows at a fixed rate could use an Interest Rate Swap to change their borrowing from a fixed rate to floating rates.
This is a simple illustration of Liability Swap deal.