What is 'Quality Spread Differential (QSD)'

Quality spread differential (QSD) is used to calculate the difference between market interest rates that the two parties potentially entering into an interest rate swap are able to achieve. QSD is a measure companies can use to gauge interest rate swap counterparty default risk.

BREAKING DOWN 'Quality Spread Differential (QSD)'

Quality spread differential is a measure used in interest rate swap analysis. Companies use a quality spread differential to gauge default risk.

Interest Rate Swaps

Interest rate swaps trade on institutional market exchanges or through direct agreements between counterparties. They allow one entity to swap their credit risk with another using different types of credit instruments.

A typical interest rate swap will include a fixed rate and a floating rate. A company that seeks to hedge against paying higher rates on its floating rate bonds in a rising rate environment would swap the floating rate debt for fixed rate debt. The counterparty takes the opposite view of the market and believes they think rates will fall so they want the floating rate debt to payoff their obligations and obtain a profit.

As an example, a bank may swap its floating rate bond debt currently at 6% for fixed rate bond debt of 6%. Companies can match debt with varying maturity lengths depending on the swap contract length. Each company agrees to the swap using instruments they have issued.

Quality Spread

A quality spread provides a credit quality measure for both parties involved in an interest rate swap. The quality differential is calculated by subtracting the contracted market rate by the rate available to the counterparty on similar rate instruments.

For example, Company A swapping its floating rate debt will receive a fixed rate. Company B swapping its fixed rate debt will receive a floating rate. The quality spread differential is usually not calculated based on the rates of the instruments used.

If Company A (AAA-rated) uses two-year term floating rate debt at 6% and Company B (BBB-rated) uses five-year fixed rate debt at a rate of 6% then the quality spread differential would need to be calculated based on the rates versus the market rates. Company A’s 6% rate on two-year floating rate debt compares to a 7% rate obtained for Company B on two-year floating rate debt so this quality spread is 1%. For five-year fixed rate debt Company A pays 4% where Company B pays 6% so the quality spread is 2%. The key is to use similar products in the quality spread calculation in order to compare rates of similar issues.

Quality Spread Differential

The quality spread differential is the difference between the two quality spreads. The quality spread differential is the premium differential on the fixed- rate debt minus the premium differential on the floating-rate debt. In the above example this would be 2% - 1% resulting in 1%. A positive quality spread differential indicates that a swap is in the interest of both parties because there is favorable default risk. If the AAA-rated company had a significantly higher floating rate premium to the lower credit quality company than it would result in a negative quality spread differential and would likely cause the higher rated company to seek a higher rated counterpart.

RELATED TERMS
  1. Liability Swap

    A liability swap is a financial derivative in which two parties ...
  2. Interest Rate Swap

    An interest rate swap is a forward contract in which one stream ...
  3. Swap Curve

    A swap curve identifies the relationship between swap rates at ...
  4. Inflation Swap

    An inflation swap is a transaction in which two parties exchange ...
  5. Swap Bank

    A swap bank is an institution that acts as a broker to two unnamed ...
  6. Reversible Swap

    A reversible swap is an exchange of cash flows that allows one ...
Related Articles
  1. Investing

    How To Read Interest Rate Swap Quotes

    Puzzled by interest rate swap quotes terminology? Investopedia explains how to read the interest rate swap quotes
  2. Trading

    How To Value Interest Rate Swaps

    An interest rate swap is a contractual agreement between two parties agreeing to exchange cash flows of an underlying asset for a fixed period of time.
  3. Managing Wealth

    An In-Depth Look at the Swap Market

    The swap market plays an important role in the global financial marketplace; find out what you need to know about it.
  4. Trading

    Different Types of Swaps

    Identify and explore the most common types of swap contracts. Swaps are derivative instruments that represent an agreement between two parties to exchange a series of cash flows over a specific ...
  5. Trading

    An Introduction To Swaps

    Learn how these derivatives work and how companies can benefit from them.
  6. Trading

    What Warren Buffet Calls "Weapons of Mass Destruction": Understanding the Swap Industry

    A full analysis of how the swap industry works.
  7. Investing

    CFTC Probes Banks' Use of Interest Rate Swaps

    U.S. regulators are probing banks' trading and clearing of interest rate swaps, which played a central role in the 2008 financial crisis
  8. Trading

    Introduction To Counterparty Risk

    Unlike a funded loan, the exposure from a credit derivative is complicated. Find out everything you need to know about counterparty risk.
  9. Trading

    Hedging with currency swaps

    The wrong currency movement can crush positive portfolio returns. Find out how to hedge against it with currency swaps.
  10. Managing Wealth

    Managing interest rate risk

    Interest rate risk is the risk that arises when the absolute level of interest rates fluctuate and directly affects the values of fixed-income securities.
RELATED FAQS
  1. What is a Debt for Equity Swap?

    Learn why companies issue debt for equity swaps, what they are, and how they impact shareholders and debt holders. Read Answer >>
  2. Why is product differentiation important in today's financial climate?

    Learn the importance of product differentiation and how businesses today are utilizing it to set themselves apart from the ... Read Answer >>
  3. In what types of financial situations would credit spread risk be applied instead ...

    Find out when credit risk is realized as spread risk and when it is realized as default risk, and learn why market participants ... Read Answer >>
  4. What's the difference between a credit spread and a debit spread?

    Learn about debit and credit option spread strategies, how these strategies are used, and the differences between debit spreads ... Read Answer >>
Trading Center