Work out the swap spread at a given maturity and explain what it means
The idea
The swap spread for a maturity is the swap rate minus the government bond yield of the same maturity. With a five-year swap rate of 3.55% and a five-year government yield of 3.15%, the spread is 40 basis points. It measures, roughly, the extra credit and liquidity risk of the banking system over the government, together with supply and demand effects in each market. A widening swap spread usually signals greater bank credit risk or scarcer government bonds. Swap spreads can even turn negative when government bond supply is heavy or dealers' balance sheets are constrained. The usual error is subtracting in the wrong direction or mixing maturities.
In the app: 1 practice questions on this outcome, a narrated walkthrough with diagrams, spaced review that brings it back before you forget it.
Take the free diagnostic →More in The Term Structure and Interest Rate Dynamics
- Explain how the yield curve's shape, spot and forward rates, yield to maturity, and expected and realized bond returns relate to one another
- Explain how bootstrapping extracts zero-coupon (spot) rates from the par curve
- Explain what active bond managers assume about how future spot rates will evolve compared with today's forward rates
- Explain the rolling-down-the-yield-curve strategy
- Explain what the swap rate curve is, and the reasons and ways that market participants rely on it when valuing instruments
- Explain the short-term rate spreads that serve as gauges of credit and liquidity risk across the economy
- Explain the traditional term structure theories and set out what each one implies for forward rates and for the yield curve's shape
- Explain how to measure a bond's sensitivity to each factor that moves the yield curve, and how to use those sensitivities to manage yield curve risk
- Explain the term structure of yield volatility and how it influences the volatility of prices
- Explain how major economic drivers feed into a view on spreads, benchmark rates and shifts in the yield curve