borrow cost, the funding spread and the tax adjustment

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NicoLondon

Junior Member

Posts: 15

Joined: Feb 2005

Wed Jan 10, 07 11:25 AM

Hi all,

I read in an article that the Asset Swap Spread could be defined as the sum of three components: the borrow cost, the funding spread and the tax adjustment.

I have tried to find the exact definitions of the three components but I did not find anything.

Could someone give me succint explanations of what are theses three quantities ?

Many thanks.

Nico

koubliac

Junior Member

Posts: 2

Joined: Dec 2006

Thu Jan 11, 07 01:39 PM

It's the same components that go into pricing a future.

Take the example of a total return asset swap over 1000 shares of equity AAA. You go to the broker and want to receive the economic performance of 1000 shares of AAA, you will pay the swap interest to the broker (LIBOR say + swap spread). The broker goes to the market to hedge the swap, and buys 1000 shares of AAA using borrowed cash. Assume he pays LIBOR + 4bps on his borrowed cash, therefore he will charge you the 4 bps on the swap interest, and probably a bit more - this is the funding spread.

Assume that AAA pays a dividend. If you held physically held AAA you would only receive 85% of the dividend due to 15% witholding tax (say). Assume that the broker also would only receive 85%. As it's a TRS, the broker will pay you the dividend as a payment or an increased swap spread over term. The amount of the payment depends on the tax rate.

Next case is that if you want to pay performance of equity AAA. The broker will short AAA to hedge. To faciliate the short, he will need to borrow the AAA from a stock borrow desk - this is the borrow cost. Which you end up paying as a rebate on the swap interest i.e. LIBOR - borrow cost.

NicoLondon

Junior Member

Posts: 15

Joined: Feb 2005

Thu Jan 11, 07 04:10 PM

Many thanks koubliac .. I understand quite better now ;-)

Thanks a lot again

Nico