Swap Curve

What Is a Swap Curve?

A swap curve distinguishes the relationship between swap rates at different maturities. A swap curve is really the name given to the swap's equivalent of a yield curve.

The yield curve and swap curve are of comparative shape. Notwithstanding, there can be differences between the two. This difference, which can be positive or negative, is alluded to as the swap spread. For instance, in the event that the rate on a 10-year swap is 4% and the rate on a 10-year Treasury is 3.5%, the swap spread will be 50 basis points. The swap spread on a given contract demonstrates the associated level of risk, which increments as the spread enlarges.

Understanding Swap Curves

At the point when people and organizations borrow money from a lending institution, for example, a bank, they need to make interest payments on the loaned amount. The interest rates applied to a loan can either be fixed or floating rates. Now and then an entity with a fixed rate loan could like to have a loan with a floating rate all things being equal, and a company with a floating interest payment could like to make fixed payments. The two companies can go into a contractual agreement known as a interest rate swap.

An interest rate swap is a financial derivative which includes the swapping or exchange of interest rates. One counterparty will pay a fixed rate, and the other will pay a floating rate in light of a benchmark, like the LIBOR, EURIBOR, or BBSY. At contract inception, swaps are generally priced to have zero initial value and zero net cash flow. For instance, consider a swap went into by two elements in which one party has a loan with a 4.5% fixed interest. In the event that the LIBOR is expected to stay at 3.5%, the contract will specify that the party paying the floating interest rate will pay LIBOR plus a margin. In this case, since the swap contract must have zero value at the commencement point, the floating payment will be 3.5% + 1% (or 100 basis points), equivalent to the fixed rate. As time passes by, interest rates change, bringing about a change in the floating interest rate.

At the point when interest rates change, the swap rate statements given by banks will likewise change. Every day, data on swap rates across different maturities quoted by banks are collected and plotted on a graph, known as the swap curve. Due to the time value of money and the expectations of changes in the reference rate, various maturities will have different swap rates.

Utilizing the Swap Curve

Utilized in basically the same manner as a bond yield curve, the swap curve assists with distinguishing various qualities of the swap rate versus time. The swap rates are plotted on the y-hub, and the opportunity to maturity dates are plotted on the x-pivot. Thus, a swap curve will have various rates for 1-month LIBOR, 3-month LIBOR, half year LIBOR, etc. In other words, the swap curve shows investors the conceivable return that can be acquired for a swap on various maturity dates. The more extended the term to maturity on an interest rate swap, the greater its sensitivity to interest rate changes. Also, since longer-term swap rates are higher than short-term swap rates, the swap curve is ordinarily up inclining.

The swap curve is utilized in financial markets as a benchmark for laying out the funds rate, which is utilized to price fixed income products, for example, corporate bonds and mortgage-backed securities (MBS). Over-the-counter derivatives, for example, nonvanilla swaps and forex futures are priced in view of the data portrayed on the swap curve. What's more, the swap curve is utilized to measure the aggregate market view of conditions in the fixed-income market.

Features

• Differences between the swap curve and the yield curve (for example LIBOR) characterize the swap spread for a given maturity.
• A swap curve portrays the implied yield curve in view of the floating rates associated with an interest rate swap.
• Swap spreads are utilized to comprehend the time value of money and how interest rates in the market change with time to maturity.