Tikona Credit Fund buys a five-year 9.2% bond of Mahuli Infra at 101 and swaps it to floating with a par asset swap. The five-year swap rate is 7.0% and the annuity factor 4.1. What is the asset swap spread, and what is the fund still exposed to?

The asset swap spread is about 196 bp over floating: 220 bp of excess coupon less 24.4 bp a year to repay the point above par. That is Rs 1.96 crore a year on Rs 100 crore. The swap removes the interest rate risk, so what remains is almost pure Mahuli credit risk: if Mahuli defaults, Tikona keeps paying fixed on a swap with no bond behind it, and loses par less recovery. It also carries the dealer's credit on the swap.

Take a fixed-rate bond and ask what it would pay if it were a floating-rate loan. Think of renting out a flat on a fixed five-year lease when you would rather have rent that tracks the market: you agree with someone else to hand them the fixed rent and receive a market-linked rent plus a margin. In a par asset swap the fund pays par for the bond, gives the bond's fixed 9.2% coupons to the dealer, and receives floating plus a spread, so the spread is the bond's credit premium restated over floating. Because the fixed coupons in and out cancel, rate moves no longer change what Tikona earns. The word par matters: Tikona pays Rs 100 crore even though the bond costs Rs 101 crore, and the dealer funds the difference.

Set it up as a fair exchange for the dealer. Each year the dealer receives 9.2% and pays floating plus a spread s. A five-year swap at 7.0% says fixed 7.0% is worth the same as floating, so the dealer is ahead by 9.2 less 7.0, 2.2% a year, less s. At the start the dealer is behind by 1 point, the premium it funded. Fairness means 2.2% less s, times the annuity factor of 4.1, equals 1 point, so s is 2.2% less 1 divided by 4.1, which is 2.2% less 0.244%, or 1.956%, about 196 bp. The annuity factor converts a lump sum today into an equal amount each year, which is why the 1 point becomes 24.4 bp rather than 20 bp: discounting means a rupee today buys more than a fifth of a rupee a year for five years.

Start with what it is not exposed to: a rise in rates no longer hurts, because Tikona earns floating plus 196 bp and floating rises with rates. What remains is Mahuli's credit, and the swap makes a default slightly more awkward, not less: the bond stops paying, but the swap does not stop, so Tikona must either keep paying 9.2% fixed with nothing coming in or close the swap at its market value. If rates have fallen since the start, that close-out costs money on top of the bond loss; if they have risen, it pays some back. On Rs 100 crore with an assumed recovery of 40%, the bond loss is Rs 60 crore of par, and Tikona paid par, not 101, which is one of the reasons funds prefer the par structure. Two more risks sit behind it: the dealer's own credit on the swap, which collateral reduces, and the day-count and payment-date mismatch between the bond and the swap, small but real.

Close with what the 196 bp is for. It is the market's price of five years of Mahuli credit risk, stated over floating, and the fund should compare it with Mahuli's five-year credit default swap spread: if the asset swap pays more than the CDS costs, buying the bond, swapping it and buying protection would lock in the difference, a gap traders call the basisThe difference between a CDS spread and a bond asset swap spread on the same issuer and maturity. Funding costs and delivery options keep it from being zero.. State the limitation: the annuity factor of 4.1 is taken as given, and on a real trade the dealer computes it from the swap curve and the exact payment dates, which can move the spread by a basis point or two.