Pricing

Credit trades at different spread levels in different product sectors. The spread in the
corporate bond market may differ from the loan market, and each may differ from
the spread available in the credit derivatives market. Indeed, credit derivatives allow
institutions to arbitrage the different sectors of the credit market, allowing for a more
complete market.
With an asset swap, an investor can synthetically transform a fixed-rate security
into a floating rate security, or vice versa. For example, if a corporate bond trades at
a fixed yield of 6%, an investor can pay a fixed rate on an interest rate swap (and
receive LIBOR), to create a synthetic floater. If the swap fixed rate is 5.80%, the
floater yields LIBOR plus 20 basis points. The spread over LIBOR on the synthetic
floater is often compared to the market price for a default swap as an indicator of
value. If the fee on the default swap exceeds, in this example, 20 basis points, the
default swap is ‘cheap’ to the asset swap, thereby representing value.
While benchmark indicators are convenient, they do not consider all the factors a
bank should evaluate when selling protection. For example, when comparing credit
derivative and cash market pricing levels, banks should consider the liquidity disadvantage
of credit derivatives, their higher legal risks, and the lower information
quality generally available when compared to a direct credit relationship.
Using asset swap levels to determine appropriate compensation for selling credit
protection also considers the exposure in isolation, for it ignores how the new
exposure impacts aggregate portfolio risk, a far more important consideration. The
protection seller should consider whether the addition of the exposure increases the
diversification of the protection seller’s portfolio, or exacerbates an existing concern
about concentration. Depending on the impact of the additional credit exposure on
its overall portfolio risk, a protection seller may find that the benchmark pricing
guide; i.e. asset swaps, fails to provide sufficient reward for the incremental risk
taken. Banks face this same issue when extending traditional credit directly to a
borrower. The increasing desire to measure the portfolio impacts of credit decisions
has led to the development of models to quantify how incremental exposures could
impact aggregate portfolio risk.