The I-spread ("mid swap spread" or yield-yield spread) is a standlone measure of credit risk, a security against matched maturity vanilla swap rate. Consider a package in which the investor receives security's coupon and takes credit risk: interest rate exposure is delta-hedged with a matched-maturity swap.

The asset swap (ASW)-spread is a measure of total return, because coupon and principle cashflows are discounted at prevailing swap rate. Upfront principle, which may be large if the security price is far from par, means that the ASW-/I-spreads are often highly divergent.

Is there a closed form soln to convert from one to the other?

The asset swap spread is the amortised repayment of the difference in price between a specific credit risky bond and the price of that same bond discounted on the Libor swap curve. It is written as

$D=\frac{P_{Libor}-P}{\rm PV01}$

where $PV01$ is the the annuity of the swap floating leg and $P_{Libor}$ is the discounted bond price on the Libor curve and $P$ is its actual market price.

The repayment is risk free in the sense that the swap leg of the asset swap must continue to the maturity of the asset swap i.e. the swap does not cancel even if the asset defaults. As it depends on the price in the market of the bond, it does depend on the credit risk of that bond which is embedded in its market price and so it is risk-adjusted. As it determines cash flow sizes in a real trade, the asset swap spread is more than just a measure of credit risk.

Your definition of an I-swap is not complete. Can you explain exactly how it is calculated. Does the swap cancel with the bond ?

• Bond investor buys the security and pays market rate on matched maturity swap. I.e. I-spread package. – rrg Aug 9 '16 at 13:09
• What happens if bond defaults ? Also does swap fixed leg coupon equal swap rate or bond coupon ? – Dom Aug 9 '16 at 14:19
• This is explained in the question. It's a very standard risk measure. Investor receives ful cpn from the security and takes risk on all other vars except interest rate PV01 which is hedged matched maturtiy at time of pricing. – rrg Aug 9 '16 at 14:33
• No. You never said what happens to swap if bond defaults. – Dom Aug 9 '16 at 14:40
• We prefer not to consider such adverse scenario this time – rrg Aug 10 '16 at 18:08