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, but unfortunately they are not readily available to the general public.

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.