Swap Spreads: Understanding the Difference and its Significance

The swap spread is the difference between the swap rate (the rate of the fixed leg of a swap) and the yield on the government bond with a similar maturity. Since government bonds (e.g., US Treasury securitiesTreasury Bills (T-Bills)Treasury Bills (or T-Bills for short) are a short-term financial instrument issued by the US Treasury with maturity periods from a few days up to 52 weeks.) are considered risk-free securities, swap spreads typically reflect the risk levels perceived by the parties involved in a swap agreement. Swaps are frequently quoted as the swap spread (another option is the swap rate).

Swap Spread and Market Risk

The swap spreads of interest rate swapsInterest Rate SwapAn interest rate swap is a derivative contract through which two counterparties agree to exchange one stream of future interest payments for another are considered typical indicators of market risk and a measure of the risk aversion prevalent in the market. Swap spreads are commonly used by economists in assessing current market conditions.

Large positive swap spreads generally indicate that a greater number of market participants are willing to swap their risk exposures. As the number of counterparties willing to hedge their risk exposures increase, the larger the amounts of money that parties are keen to spend to enter swap agreements. Such a trend generally reveals strong risk aversion among the market participants,Key Players in the Capital MarketsIn this article, we provide a general overview of the key players and their respective roles in the capital markets. The capital markets consist of two types of markets: primary and secondary. This guide will provide an overview of all the major companies and careers across the capital markets. which can be caused by a high level of systematic risk in the market.

Additionally, large spreads may signify reduced liquidity in the market. This is generally caused by the greater portion of capital employed in the swap deals.

Example

ABC Corp. enters into an interest rate swap agreement with XYZ Corp. It is a 3-year interest rate swap in which ABC Corp. (the payer) must pay a 3% fixed interest rate, while XYZ Corp. (the receiver) must pay the floating interest rate that equals 1-year LIBORLIBORLIBOR, which is an acronym of London Interbank Offer Rate, refers to the interest rate that UK banks charge other financial institutions for. The current 3-year yield on the default-free government bond is 1.5%.

In order to calculate the spread of the swap, we need to determine its swap rate. According to the definition, the swap rate is the fixed rate of the swap. Thus, the swap rate of the swap contract between ABC Corp. and XYZ Corp. is 3%, which represents the swap’s fixed rate.

Therefore, the swap spread, which is the difference between the swap rate and the yield on a government bond with a similar maturity, is calculated using the following formula:

Additional Resources

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