Swap Spread

Swap Spread




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Swap Spread
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Swap spreads are the difference between the swap rate (a fixed interest rate) and a corresponding government bond yield with the same maturity ( Treasury securities in the case of the United States). [1]

For example, if the current market rate for a five-year swap is 1.35 percent and the current yield on the five-year Treasury note is 1.33 percent, the five-year swap spread would be 0.02 percentage points, or 2 basis points . [2] [3]

Often, fixed income prices will be quoted in "SWAPS +", wherein the swap rate is added to a given number of basis points. The swap rate there is simply the yield on an equal-maturity Treasury plus the swap spread.

Swap spread became a popular indication of credit spread in Europe during the 1990s.

This finance-related article is a stub . You can help Wikipedia by expanding it .

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It is the difference between the fixed aspect of a particular swap and a related sovereign debt security's yield with the same maturity.
A swap spread is a difference between the fixed aspect of a particular swap and a related sovereign debt security's yield with the same maturity . In the United States, the latter is a treasury bill issued by the government.
Before delving into the world of swap rates, let us briefly refresh your memory on what a swap is.
A swap is a derivative contract that allows two parties to exchange a distinct financial instrument's liabilities or cash flows for another. 
Since swaps are not traded on exchanges, they are mostly bought and sold by businesses or financial institutions in over-the-counter contracts.
Now, of the two instruments being exchanged, one has a fixed cash flow, and the other has a variable one. 
When calculating the swap rate, we consider the fixed cash flow.
Since treasury bills are essentially risk-free financial instruments, the spread on a particular contract is determined by the perceived risk of the agents involved in the transaction.
Perceived risk shares a direct relationship with the swap spread.
This direct relationship allows parties to determine the creditworthiness of their counterpart through the swap spread.
In general, three components make up the difference between swap rates and government bond yields
This is the difference between the fixed component of an interest rate swap and a corresponding risk-free rate, such as a treasury bill. Typically, banks borrow at a rate higher than the risk-free rate.
Bank credit is pro-cyclical, i.e., it increases during bad economic conditions and reduces during good financial conditions.
This is the difference between the bond rate and the corresponding risk-free rate. 
When demand for bonds is high, the bond premium tends to be lower. On the other hand, when there is a low demand for bonds, the bond premium is more significant.
This is the difference between bonds and bond futures . 
It is essentially a mix of the repo -forward (difference between current bond yields & the forward rate for which an investor is indifferent between buying now/later) & the bond-basket basis (difference between repo-forwards & bond future yield). 
Over the past few years, basis has been the least significant factor affecting these spreads because it is relatively small.
Consider an interest rate swap. These swaps have a higher level of credit risk than safe government bonds, so these can be seen as compensation for taking on this increased risk.
In other words, these instruments allow the transacting parties to manage their risk.
Suppose interest rates increase while the swap is still in effect. In that case, the party receiving the fixed interest rate incurs a loss, whereas the party receiving the variable interest rate makes a profit. We will consider an example in the next section to better understand this.
The fixed-rate receiver requests a charge in addition to fixed-rate flows to cover these risks. This is where the spread comes in.
They are similar to credit spreads in that they reflect the perceived risk of the other party defaulting on the agreed contract.
A well-defined interest rate swap contract clearly states parameters such as the start date, interest rates paid by either party, payment terms (quarterly, annually, etc.), and maturity date. In addition, both parties must abide by the conditions of the agreement until the contract matures.
Let us now look at an example to understand better how these work.
Consider a 10-year swap with a fixed rate of 5% and a 10-year treasury bill with a fixed rate of 2%. For this example, we assume that the treasury bill has the same maturity date as the swap.
We know from previous sections that the formula for calculating the spread is simply the difference between the swap's fixed rate and the treasury bill yield.
In other words, it is 3% or 300 basis points .
To solidify our understanding, let us consider another example. Before you look at the answer, try solving it yourself!
Suppose the fixed rate of a 7-year swap is 4%, and that of a 7-year treasury bill is 3.25%. What would the swap spread be in this case?
Again, we calculate the difference between the fixed rate and the treasury bill yield.
Therefore, it is 0.75% or 75 basis points.
As discussed previously, swaps are a means of hedging risk. Swap spreads indicate the desire of two economic agents to hedge risk, the cost of the hedge, and the overall liquidity in the market.
As postulated by the economic model of supply and demand, the greater the need for swaps, the higher their price will be.
Thus, the greater the number of agents wishing to hedge risk, the higher they must be willing to pay to induce the counterparty to accept that risk.
This implies that a more extensive spread (the fixed rate is much higher than the government bond yield) signals a higher market risk aversion. As a result, few agents are willing to accept the high risk accompanying the swap.
Additionally, it indicates that liquidity has significantly decreased, as it did during the 2008 financial crisis .
It also serves as an indicator of systemic risk within institutions or the economy as a whole. 
Systemic risk is the possibility that the entire financial system or market will fail. It can be catastrophic, so gauging the likelihood of this risk is essential for any industry or institution.
So far, the swap spreads we have looked at have been favorable. However, they may likely be harmful.
The swap spreads on 30-year treasury bills have been negative since 2008.
The Chinese government sold US treasuries in late 2015 to ease restrictions on reserve requirements for its local banks, which caused the spread of 10-year T-bonds to become harmful.
But what does this negative rate mean? For starters, it could mean that the market considers its bonds risky assets. This is especially true after the 2008 financial crisis when private banks were bailed out and treasury bonds sold off.
However, the above reasoning does not explain the popularity of treasury bills with a shorter maturity time, such as two years.
Another explanation could be that trading firms have started holding fewer long-term fixed-income securities. Therefore, they do not require as much compensation for their exposure to fixed-term swap rates.
Some studies also suggest that restrictions have made it much more expensive to enter a trade to increase it since the financial crisis. This has led to a decrease in the return on equity and, thus, a fall in the number of traders willing to enter such swaps.
The following section recapitulates what we have learned throughout this discussion. Mentioned below is the summary:
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A swap spread is the difference in the interest rate between an interest rate swap and government bond yield of the same maturity (for instance, a United States Treasury security). It is used as a measure of the difference in credit risk between a corporation and a sovereign bond.
Swap spreads in the United States have been moving lower ever since the 2008 financial crisis. In fact, in the 10 and 30 year sectors, the swap rate is lower than the Treasury rate. Some commentators argue this means there will be a higher future cost in funding the government.
Historically, the swap spread was used as a measure of corporate credit risk. As sovereign risk barely moved, any move in the swap spread was, by definition, due to changing perceptions of the credit risk of corporations. The 2008 financial crisis changed that dynamic, with some European sovereign bonds – notably Greek – pricing in a chance of government default. Today, the swap spread moves on more technical and structural factors. An example is the move towards swap execution facilities and centralised clearing of swap transactions, which removes much of the credit risk normally associated with the swap market.
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A swap spread is the difference between the fixed rate component of a given swap and the yield on a Treasury item or other fixed-income investment with a similar maturity .
Companies engage in swaps in order to benefit from an exchange of comparative interest rate advantage. The terms of a plain vanilla (i.e. straightforward) swap are highly variable from contract to contract based on the needs of and resources available to the participating counterparties. A Treasury bond is often used as a benchmark because its rate is considered risk-free. The swap spread on a given contract indicates the associated level of risk. Risk increases as the spread widens. For instance, if one 10-year swap, XYZ, has a fixed rate of seven percent and a 10-year Treasury bond with the same maturity date has a fixed rate of five percent, the swap spread would be two percent (200 basis points ) (7% - 5% = 2%).
As a reflection of risk, swap spreads are often used to assess the creditworthiness of participating parties.
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