Swap Rate, Swap Curve, and Swap Spread

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Let’s delve into three pivotal concepts recurrently surfacing in the derivatives arena, notably swaps, and dissect their implications.

Swap Rate

Allow me to elucidate with a quintessential example of an interest rate swap contract. Parties A and B are parties to a 5-year swap agreement, wherein, at each year’s end, A disburses a fixed rate of 2% to B, while B reciprocates by disbursing an amount tied to the 3-month LIBOR at the payment juncture, with both parties dealing in $100,000 denominations. The pivotal query arises: Why does A accede to a 2% payment to B instead of 1% or 3%?

To resolve this quandary, let’s partition this swap contract into two discrete bond transactions:

1. A procures bond (1) issued by B at a rate pegged to the 3-month LIBOR, with a principal value of $100,000.
2. B procures bond (2) issued by A at a fixed rate of 2%, with a principal value of $100,000.

At the contract’s onset, the values of the aforesaid bonds can be ascertained based on the present value of future cash flows (referencing the bond article for elaboration). For a transaction to transpire sans any initial cash outlay, the market value of both bond types must be congruent. Pricing bond (2) is straightforward, whereas bond (1) poses a more intricate valuation. Consequently, the contracting parties reference the market price of bond (1), then delineate the rate for bond (2) to equalize its price with that of bond (1). Hence, do you now possess the answer?

Subsequently, the fixed rate of 2% in the aforementioned scenario is denominated as the swap rate. Ergo, the swap rate epitomizes the fixed interest rate within the underlying interest rate swap contract, predicated on (1) the reference interest rate, (2) the tenure, and (3) the discount rate (entailing factors such as liquidity, supply, and demand).

In essence, the swap rate signifies the fixed interest rate employable to supplant a floating rate within a specific tenure.

Given that swap transactions transpire over-the-counter (OTC), their liquidity quotient is relatively subdued. Hence, one cannot hinge on market swap transactions to forge historical swap rate data, akin to bond yields or any other centrally traded assets. Market swap rates are computed by esteemed financial institutions grounded on available information reservoirs. One of the credentialed entities frequently updating swap rates across various tenures is ICE, whose swap rate data garners widespread adoption by premier financial news platforms like Bloomberg and the Financial Times.

The ubiquitous reference interest rate for prevalent swap rates in the market, recurrently encountered on financial news portals, is the 3-month LIBOR.

Significance

A higher swap rate connotes an enlarged anticipated reference rate in the future (as per the swap rate determination principle). Consequently, from the swap rate, we can extrapolate the anticipated LIBOR rate for investors at the maturity juncture. Furthermore, swap rates are also instrumental in assessing the value of financial assets by financial institutions, given that many banks deploy swaps to hedge against interest rate vicissitudes.

OIS Rate

Overnight-index swaps (OIS) embody fundamental interest rate swap contracts, wherein the floating interest rate predominantly mirrors the interbank overnight rate, conventionally employed as the policy rate by central banks. OIS contracts typically sport truncated tenures, thereby orchestrating payment streams of these swap agreements at the maturity threshold. The OIS rate precisely mirrors the swap rate of this swap contract, encapsulating the anticipated overnight rate in the future (at the maturity date).

Swap Curve

The swap curve delineates the nexus between swap rates across diverse tenures, paralleling the yield curve.

The swap curve also serves as a yardstick to determine swap rates and appraise various financial assets in the market, given that swap rates lack the multiplicity of tenures requisite for analysts.

Additionally, since the swap rate is a variable instrumental in reflecting investors’ anticipations of interest rates, the swap curve is also leveraged to gauge investors’ forecasts of interest rates at disparate temporal epochs. An ascending swap curve mirrors investors’ anticipation of burgeoning interest rates in the future, and vice versa.

A more prevalent variant of the swap curve is the OIS curve, given that the OIS rate directly mirrors the policy rate anticipations of central banks.

Swap Spread

Swap spread signifies the deviation between the swap rate and the government bond yield at an equivalent tenure (or risk-free rate). For instance, if the 10-year swap rate for the 6-month LIBOR is 2%, and the 10-year government bond yield stands at 1.5%, the swap spread would aggregate to 2% – 1.5% = 0.5%.

Swap spread quantifies the credit market’s risk and the participation of frequent stakeholders in swaps, such as swap dealers. If the market perceives an escalation in an entity’s risk, the likelihood of them honoring the payment obligations per the swap contract’s stipulations will dwindle. Consequently, the swap rate must escalate to indemnify the risk borne by the counterparty.

Swap spread also quantifies the cost of hedging risk. For instance, if one procures a 10-year government bond with a 1.5% interest rate and hedges it with swaps, transmuting the fixed 2% rate to a floating rate equivalent to the 3-month LIBOR. In such an event, the regular interest payment for the two transactions aggregates to 1.5% + LIBOR – 2% = LIBOR – 0.5%. This conveys that one cannot fully transmute the bond interest rate to LIBOR, thereby incurring a 0.5% interest loss, which is the swap spread and is construed as the cost of risk hedging.

Given that swap rates are computed based on LIBOR, they are not risk-free rates. Consequently, the swap spread will perennially surpass 0. Nevertheless, an exception transpired during the 2008 financial cataclysm, subsequent to Lehman Brothers’ bankruptcy, where all market liquidity dissipated swiftly, and traders harbored apprehensions regarding swap dealers’ default risks. Consequently, swap transactions plummeted in popularity, and the 30-year swap rate in the US plummeted below the 30-year bond yield.