Asset swaps are seen to be both cash market instruments and credit derivatives in the financial markets. They are similar in structure to plain vanilla swaps and the difference between the two instruments is in the underlying swap contract. Plain vanilla swaps exchange fixed and floating interest rate products whereas asset swaps exchange fixed rate investments such as bonds which pay a guaranteed coupon rate with floating rate investments such as an index. Asset swaps are used to alter the cash flow profile of a bond.
The asset swap market is an important component in the credit derivatives market, as it explicitly states the cost of credit as a spread over LIBOR (London Interbank Offered Rate).
Asset swaps package together transactions in which an investor buys a bond and then enters into an interest rate swap with the financial institution which sold them the bond. The seller of the swap (the financial institution) will then agree to pay the buyer LIBOR +/- a spread in return for the fixed cash flows from the bond. This then transforms the fixed coupon rate of the bond into a LIBOR based floating coupon since LIBOR is a floating rate.
Pricing a bond with reference to LIBOR is a commonly used tool and the spread between the bond rate and LIBOR serves as a measure of the credit risk of the cash flows of the underlying bond. The larger the spread above LIBOR, the more risky the associated cash flows. Assets swaps enable investors to transform the cash flow characteristics of the bonds they hold and allow them to hedge currency, credit and interest rate risks by creating synthetic investment products which have more suitable cash flow characteristics. In the event of a default by the bond issuer, a buyer of an asset swap will continue to receive the payment of LIBOR +/- the spread from the seller of the asset swap. This allows the buyer of the asset swap to transform his original risk profile by altering the interest rate return and the credit risk exposure.
The way asset swaps work will be easier to understand once we look at the picture below.
We see that two parties participate in the transaction. One of them, denoted as Payer, holds a fixed-rate asset (e.g. a U.S. Treasury bond) and receives a fixed coupon from it. The Payer enters a deal with another party, denoted as Receiver. The deal is that the Payer agrees pay the Receiver a fixed rate which is usually very close to the rate paid by the abovementioned fixed-rate asset. After short consideration, we come to the conclusion that the Payer gets rid of the fixed-rate. In return the Payer gets a floating rate from the Receiver. The final outcome for the Payer is that they receive a floating rate instead of a fixed one.