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Research & Publications | |
| Back-to-Basics |
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The following article is reprinted from the November/December, 1999 issue of
On the Edge, the Interactive Data Fixed Income Analytics bimonthly newsletter.
Back-to-Basics: The Swap Curve
Teri Geske Most fixed income practitioners now have some experience or familiarity with interest rate swaps. Swaps have been around since the early ‘80s and represent the largest share of derivatives market activity. Since the swap market is a source of information about expectations for credit risk and loan demand, even those who have no plans to use interest rate swaps in their portfolios watch this market regularly. So, in this month’s Back-to-Basics column, we thought we would take a look at some key features of the interest rate swap market. An interest rate swap is a derivative, but like interest rate futures and forward rate agreements, swaps have no "option risk" and thus no volatility risk. Swaps do, however, have liquidity and credit risk, which are discussed below. To recap the basics of a "plain vanilla" interest rate swap, two parties (e.g. a corporation and a bank) agree to exchange future or "forward" periodic interest payment, one based on a fixed rate and the other based on a floating rate index, typically LIBOR. The fixed rate quoted on an interest rate swap (the swap rate) is the rate of interest that must be paid so that the present value of the fixed rate payments is equal to the present value of the expected future short-term LIBOR payments for the life of the swap. Interest rate swaps can be used to transform a floating rate asset or liability into a fixed rate, and vice versa. Swaps can also be used to adjust the duration of a portfolio – receiving the fixed rate on an interest rate swap (and paying the floating rate) is equivalent to owning a fixed rate bond that is purchased by borrowing short-term funds. If interest rates go up, the value of receiving a fixed stream of interest payments declines, just as the value of a fixed rate bond declines, and vice versa. The rates for swaps of different maturities comprise a swap curve. Just as the Treasury yield curve implies a forecast of where (risk-free) interest rates are expected to be in the future, the swap curve implicitly contains the market consensus of how short-term LIBOR is expected to move over time, i.e., the basis for the expected future payments on the floating side of a swap1 . Swap rates are driven by yields on eurodollar futures contracts. This is because a series of eurodollar futures contracts offers almost the same exposure as the floating side of an interest rate swap. For example, if you buy a series of four eurodollar futures contracts expiring in 6 months, 1 year, 18 months and 2 years, you would have almost the same risk as if you had entered into a two year swap, where you paid a fixed rate semi-annually in exchange for receiving four semi-annual floating rate payments. Therefore, when a swap dealer quotes a rate for the fixed side a swap, the rate is based on the yield of the series of eurodollar futures contracts the dealer would use to hedge the position2. Credit and liquidity risk are the reasons swaps are not perfect substitutes for eurodollar futures. Eurodollar futures are the most liquid financial instrument in the world, whereas swaps are illiquid, individually negotiated contracts. Eurodollar futures positions are marked-to-market daily on an exchange and therefore have no credit risk (unless the exchange itself goes bankrupt). With an interest rate swap, if your counterparty defaults you must seek payment under bankruptcy proceedings and/or enter into a new swap under the prevailing (possibly adverse) terms of the current interest rate environment. The difference between the swap rate for a given maturity and the yield on a Treasury with the same maturity is called the "swap spread." For example, if the fixed rate on a 5 year swap is quoted at 6.60% and the 5 year Treasury rate is 5.85%, the five year swap spread is 85 bps (6.60% – 5.75%). What drives swap spreads? Since the swap rate is based on expected future LIBOR rates, swap spreads represents the difference between a risk-free borrowing rate and the rate at which the market expects inter-bank borrowing to occur in the future. Swap rates are quoted by large, AA-rated banks and thus reflect both the credit risk of that sector and a liquidity premium, as discussed above. So, if swap spreads widen, one interpretation is that there is an increase in the perceived credit risk for banks. Conditions in the corporate debt market also affect swap rates, as the swap market is essentially an alternative source of fixed rate funding for corporate borrowers. Consider a company that wishes to pay a fixed rate on a new borrowing. The company can either issue a fixed rate bond or it can borrow from its bank at LIBOR plus X bps and then swap the LIBOR-based borrowing into a fixed rate. Using an interest rate swap, the company would receive LIBOR (flat) and would pay the fixed swap rate to the counterparty; therefore, its all-in cost of borrowing would be the swap rate plus the X bps spread owed on its LIBOR-based bank loan. If the all-in cost of the swap is lower than the coupon rate the company would have to pay by issuing a fixed rate bond, the company would enter into the swap. Thus, overall demand for corporate borrowing will also affect expected future LIBOR rates – if borrowing needs are high, LIBOR rates will rise and swap spreads will increase. (Note that swap spreads do tend to track credit spreads in the bond market and have widened considerably since the Russian default/flight-to-quality that disrupted the bond market in the third quarter of 1998). Some fixed income market participants have begun to view the LIBOR curve implied from the swap curve as an alternative to the U.S. Treasury on-the-run yield curve as a "benchmark" off of which to value other securities. This is due, at least in part, to the impact on the on-the-run Treasury yields as the government’s borrowing needs decline and the resulting supply/demand imbalances for the on-the-run instruments. It will be interesting to see if this concept becomes more popular in the coming year. We are watching this carefully as it has implications for BondEdge. As always, we welcome your comments and suggestions about this Back-to-Basics column and encourage you to submit ideas for future topics to marketing – fia.marketing@interactivedata.com. 1 Note that since the swap rates are essentially coupon rates, deriving these implied forward LIBOR rates involves "stripping" the swap curve. 2 In practice, swap dealers typically use eurodollar futures to hedge their "residual" swap exposure; i.e., those positions which could not be hedged with other, offsetting swaps. | ||
 
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