Swap spread: Difference between revisions

Revision as of 12:47, 4 June 2025

Revision as of 12:54, 4 June 2025

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{{Short description|Financial metric}}

{{Technical}}

Swap spreads are the difference between the yield on a government bond or sovereign debt security and the fixed component of a swap, both of which have a similar time until maturity. Given that most sovereign debt securities such as government bonds are considered to be risk free securities the role of a swap spread is to reflect the risk levels of an agreement perceived by the parties ( investors) involved. Swap spreads are therefore categorised to be an economic indication tool as the size of the swap spread reflects the level of risk aversion within the financial markets. Swap spreads is a term coined by economists to generate a tool to assess current market conditions. Swap spreads have become more popular as a metric of financial forecasting and measurement as a result of their increased correlation to financial market activity and volatility. Used as an indicator of economic activity, higher swap spreads are indicative of greater risk aversion within the market place. Governments, financial markets and policy makers in general therefore utilise this metric to make decisions as it is argued to reflect market sentiment.

==History==

The term swap spreads was introduced as a result of the creation of credit default swaps (CDOs) by investment bank JP Morgan in 1994.<ref name=Fu >Fu, Li, M. C., & Molyneux, P. (2020). Credit default swap spreads: market conditions, firm performance, and the impact of the 2007–2009 financial crisis. Empirical Economics, 60(5), 2203–2225. https://doi.org/10.1007/s00181-020-01852-0

Kóbor, Shi, L., & Zelenko, I. (2005). What determines U.S. swap spreads? World Bank.</ref> CDOs generated the fundamentals of swap spreads which are now deployed to analyse a variety of core market indicators and conditions. The notional amounts of CDS’s have declined, however the structural model has been used continually to examine both firm specific and market determinants of swap spreads. Multifactor analysis of both [[microeconomics|firm specific]] and [[macroeconomics|market specific]] are aggregated in the [[economy current]] to determine the swap spread size. <ref name="Fu" />

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==Finance==

The use of the term swap-spreads in financial markets has grown progressively over time. Many economists have deconstructed swap spreads and their implications on the financial markets in order to make investment decisions within the global equity and fixed income markets. The utilization of swap spreads as a tool within the markets has grown substantially since 1994 asdue mentioned.to the growing understanding of the interrelationship between financial themes<ref>https://doi.org/10.1007/s00181-020-01852-0 Kóbor, Shi, L., & Zelenko, I. (2005). What determines U.S. swap spreads? World Bank. “Market Voice: A Negative for Swap Spreads.” Refinitiv Perspectives, 5 Jan. 2021</ref> due to the growing understanding of the interrelationship between financial themes. A swap spread is the difference between the fixed component of a given swap and the yield of a debt security. In the US this correlation triggered the emergence of derivative products and contracts as investors looked to exchange fixed interest repayments on their securities for floating rate repayments. Swap spreads as a result emerged as a mechanism to price this transition from fixed to floating rate repayments.<ref name=Lando>Feldhütter, & Lando, D. (2008). Decomposing swap spreads. Journal of Financial Economics, 88(2), 375–405. https://doi.org/10.1016/j.jfineco.2007.07.004</ref>

==Mechanics==

The Mechanics of a swap spreads (A worked example of an asset swap spread)

Swap spreads have been adopted into the pricing metrics by many financial institutions when they look to assess the value of their assets under management and future business opportunities. At the base level, swap spreads are contracts which allow people to manage their risk in which two parties agree to exchange cash flows between a fixed and floating rate holding. Simply, the swap spread rate = swap rate – yield on a government bond. <ref name=Lando /> The computation of a swap spread has evolved overtime as financial market participants look to use the data to make either short or long decisions within the financial markets.

==ConputationComputation==

The equation for a Swap Rate Spread is swap rate – Yield on Government Bond. {{Citation Needed|date=June 2025}} <br> This can be computescomputed as the following :. If a 10-year swap has a fixed rate of 4% and a 10-year Treasury note (T-note) with the same maturity date has a fixed rate of 3%, the swap spread would be 1% or 100 [[basis points]]: 4% - 3% = 1%.

Like many financial instruments developed within the money markets, swapSwap spreads have been used as a strategy by firms to arbitrage the market and generate a profit on their balance sheet positions.

<ref name=J>

J Jermann. (2020). Negative Swap Spreads and Limited Arbitrage. The Review of Financial Studies, 33(1), 212–238. https://doi.org/10.1093/rfs/hhz030 </ref>

. A long swap trade will be profitable when spreads across the instrument of interest widen. This is executed within the market by a counterparty ( counterparty A) lending out an security and receiving cash from a financial intermediary. The financial intermediary will then lend out that security to another counterparty or market participator ( counterparty B) where it will pay a fixed level of interest however receive floating interest repayments. Therefore if spreads widen, or interest rates rise they will have higher levels of interest received in comparison to what is being paid.

<ref name=B>

Chincarini, Ludwig B. The Crisis of Crowding: Quant Copycats, Ugly Models, and the New Crash Normal. Wiley, 2012.</ref>

A swap spread short can also generate profits, this will occur in an environment when swap spreads narrow. In order for financial market participants to generate profits off this movement in the market they must undertake the opposite execution as outlined earlier. During modern trading environments profitability is also evident when swap spreads become negative. <ref name=J /> This phenomenon had not been observed prior to 2008. Interestingly, the overall financial market efficiency and increase in algorithmic trading has limited the level of market arbitrage as spreads have flattened across all instruments. A spread flattening and more specifically a swap-spread tightening and tightening of the bid-ask spread identifies efficiency within this market.

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==Limitations==

Negative swap spreads however can be a sign of dysfunction in the interest-rate derivatives market. <ref name=Louise>

Bowman, Louise. “Capital Markets: Swap Spreads Signal Market Failure.” Euromoney, Euromoney, 31 July 2017, https://www.euromoney.com/article/b12knkrbxp1jnd/capital-markets-swap-spreads-signal-market-failure.

</ref> The influence of fundamental changes in the structure of capital markets which have occurred due to post crisis banking regulation is relatively unknown in regards to its influence on swap spread products. The use of swap spreads in broken financial markets is challenged as there is often an observed incoherent relationship to the movements in the financial products and the activity within the market.