Sunday, May 17, 2009

Swap spreads explained

In response to some recent questions, here is a short summary of what swap spreads are. You can also find stuff on wikipedia. I follow swaps spreads via Bloomberg, and you don't need a subscription to get a chart of swap spreads. Go to bloomberg.com and type in "ussp2:ind" in the securities field and you'll get a quote and chart. ussp5 for 5-yr swaps, etc.

Swaps are transactions that allow people to redistribute risk. They are over the counter agreements between any two parties to exchange one cash flow for another. The most basic swap is fixed rate for floating rate payments. If I own bonds (fixed rate instruments) but I worry about the prospect of interest rates rising, I might want to reduce my fixed rate exposure by entering into a swap with someone else; I would pay him the fixed rate I receive on my bonds and he would pay me a floating rate, typically Libor. I reduce my risk that way, and he increases his. He also becomes exposed to the risk that if interest rates fall, I might renege on my promise to pay him a fixed rate and he might lose out on the profit inherent in his position. In order to compensate him for these risks I need to pay him the fixed rate plus a little extra, which is the swap spread: the difference between the rate I am paying him and the rate on a Treasury bond with a maturity equal to the term of the swap agreement.

So swap spreads are a lot like credit spreads since there is counterparty risk involved. Swaps have mechanisms such as collateral agreements to minimize counterparty risk, and so can be thought of as equivalent to the spread on a AA-rated bank bond. Swap spreads are also a barometer of risk aversion in the marketplace. The more people want to swap out of their risky exposures, the more they must be willing to pay to induce others to accept that risk. So rising swap spreads equate to more risk aversion. Swap spreads can be thought of as barometers of systemic risk for the same reason.

Swaps are extremely liquid markets (much more liquid than the corporate bond market, where everything is quoted on a spread to Treasuries basis) and represent a key mechanism for the transfer and/or redistribution of risk among large institutional investors. They help make markets efficient. When they all but shut down, as they did in September, that is a sign that liquidity has dried up because a) everyone wants to reduce risk, and b) everyone is terrified of entering into any transactions because they are unable to quantify the risks out there.

Swap spreads during normal times and normal markets typically trade in the range of 30-40 basis points.

There are swap markets for all sorts of thing: interest rate swaps, credit default swaps, index swaps, currency swaps, etc.

Short version:

Swaps are agreements between two parties to exchange cash flows. In a typical swap, A pays a fixed rate of interest to B, and B pays a floating rate (Libor) to A. A also needs to pay B a spread above the fixed rate to compensate him for the increased risk he takes on.

Swap spreads are thus an indicator of how willing people are to transact with each other, how much it costs to reduce your risk, and how liquid the market is. Swap spreads can also be thought of as representing the riskiness of a generic AA rated bank--the higher the spread the more risky banks are perceived to be.

The swaps market is huge but generally restricted to large institutional investors and broker-dealers.

13 comments:

ronrasch said...

Thank you for a clear and helpful explanation, Scott. I off to Bloomberg and will be watching swap spreads. Have a great trip to Sedona. You are the best.

Eccono-monkey said...

Scott- Great pics of Sedona. Thanks for the insight into these swap markets.
All the Best

David Harper said...

Thanks, best summary of swaps spreads I've read

Jeff said...

Thanks for the explanation. It was helpful. Thanks too for the heads up on getting the charts at Bloomberg.

abida said...

This is one of the better explainations of swap spreads i have ever read. I feel the 10th time around i finally understood it on your website. Thanx a bunch

Cliff Wachtel,CPA said...

In this post you said:

Go to bloomberg.com and type in "ussp2:ind" in the securities field and you'll get a quote and chart. ussp5 for 5-yr swaps, etc.

tried this, had no luck, asked bloomberg, they said this code works only for the professional ($1200/mo) service. Is there a way to access this info on the free bloomberg service, or other free online sources? thanks, cliff (cliffw41598@yahoo.com)

Scott Grannis said...

Cliff: that is strange, because I just now went to my browser, entered bloomberg.com, and in the search field at the top of the page typed in ussp2:ind, ussp5:ind, and ussp10:ind and got exactly what I was looking for (2, 5 and 10-yr swap spreads). Anyone should be able to do this, as you can access bloomberg.com for free.

Joe5858 said...

Thanks for easy to understand explanation on swap spreads. How do you rationalize 30yr swap spreads trading negative using your argument that swap spreads are what the fixed payer is paid to compensate for taking on extra risk?

Scott Grannis said...

Negative swap spreads indicate that investors would rather have exposure to a major counterparty bank than to the US government. That's not the usual state of affairs, of course, but in this age of debt ceiling brinkmanship and out-of-control deficits it's not hard to understand. Plus, there have been times in the past when AAA corporate debt has traded through Treasuries in overseas markets (i.e., corporate yields were lower than Treasury yields of comparable maturity).

Joe5858 said...

Thank you for clearing that up.

cbt141 said...


I have read the essay on "SWAPS" and have several observations and questions. (http://scottgrannis.blogspot.com/2009/05/swap-spreads-explained.html)

First, the swap involves four concepts: 1) the long maturity debt instrument, 2) the short maturity debt instrument, 3) the long maturity coupon, and 4) the short maturity payment.

My first question is about the rational for paying a fee to the holder of the short maturity instrument. I do not understand why the short maturity owner has any more risk of counter party default of coupon transfer in the event of a fall in market interest rates than the long maturity holder has of not being given the short maturity payment in the event of a rise in rates.

"He also becomes exposed to the risk that if interest rates fall, I might renege on my promise to pay him a fixed rate and he might lose out on the profit inherent in his position. In order to compensate him for these risks I need to pay him the fixed rate plus a little extra, which is the swap spread: the difference between the rate I am paying him and the rate on a Treasury bond with a maturity equal to the term of the swap agreement."

Why are these counter party risks not balanced?

I believe that the counter party risk concerning payment transfers is balanced. Either party could respond to a market move by refusing to honor the transfer.

My second question is whether, in fact, the actual fee for the transaction is paid by the long maturity owner to the short maturity owner because the long maturity owner is paying to avoid restructuring his portfolio in a manner which either triggers a sale of an asset and an accompanying a tax event or an onerous regulatory hurdle.

The short maturity holder can restructure his own portfolio by simply allowing a short term instrument to mature and then reach out further on the maturity line for reinvestment. There is no tax consequence and likely little regulatory burden with a change in the short maturity portfolio position. However, the long maturity owner faces realizing capital gains/losses when he sells a debt instrument and seeks to reposition maturities. There might also be regulatory or actuarial restrictions that confront changes in maturity and asset choices of the long maturity owner's portfolio.

WF Smith

Perry Stearns said...

As Cliff said, "ussp2:ind" generated this message at bloomberg.com no matter which search box was used:

"The search for produced no matches Try the symbol search.

Many symbols available on the Bloomberg Professional Service are not available on Bloomberg.com. To learn more about the Bloomberg Professional Service, contact us"

But this should be an equivalent ?

http://research.stlouisfed.org/fred2/series/WSWP2

Scott Grannis said...

Perry: Apparently Bloomberg is restricting the availability of data on its public website.

The link you provide gives swap rates, not swap spreads. To get the 2-yr swap spread you would have to subtract the yield on 2-yr Treasuries from the 2-yr swap rate.