What Is a Swap Curve?
A swap curve identifies the relationship between swap rates at varying maturities. A swap curve is effectively the name given to the swap's equivalent of a yield curve.
The yield curve and swap curve are of similar shape. However, there can be differences between the two. This difference, which can be positive or negative, is referred to as the swap spread. For example, if 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 indicates the associated level of risk, which increases as the spread widens.
- A swap curve describes the implied yield curve based on the floating rates associated with an interest rate swap.
- Differences between the swap curve and the yield curve (e.g. LIBOR) define the swap spread for a given maturity.
- Swap spreads are used to understand the time value of money and how interest rates in the market change with time to maturity.
Understanding Swap Curves
When individuals and businesses borrow money from a lending institution, such as a bank, they have to make interest payments on the loaned amount. The interest rates applied to a loan can either be fixed or floating rates. Sometimes an entity with a fixed rate loan might prefer to have a loan with a floating rate instead, and a company with a floating interest payment might prefer to make fixed payments. Both companies can enter into a contractual agreement known as an interest rate swap.
An interest rate swap is a financial derivative which involves the swapping or exchange of interest rates. One counterparty will pay a fixed rate, and the other will pay a floating rate based on a benchmark, such as the LIBOR, EURIBOR, or BBSY. At contract initiation, swaps are generally priced to have zero initial value and zero net cash flow. For example, consider a swap entered into by two entities in which one party has a loan with a 4.5% fixed interest. If the LIBOR is expected to remain at 3.5%, then the contract will stipulate 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 initiation point, the floating payment will be 3.5% + 1% (or 100 basis points), equal to the fixed rate. As time goes by, interest rates change, resulting in a change in the floating interest rate.
When interest rates change, the swap rate quotes given by banks will also change. Each day, information on swap rates across various 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, different maturities will have different swap rates.
Using the Swap Curve
Used similarly as a bond yield curve, the swap curve helps to identify different characteristics of the swap rate versus time. The swap rates are plotted on the y-axis, and the time to maturity dates are plotted on the x-axis. So, a swap curve will have different rates for 1-month LIBOR, 3-month LIBOR, 6-month LIBOR, and so on. In other words, the swap curve shows investors the possible return that can be gained for a swap on different maturity dates. The longer the term to maturity on an interest rate swap, the greater its sensitivity to interest rate changes. In addition, since longer-term swap rates are higher than short-term swap rates, the swap curve is typically upward sloping.
The swap curve is used in financial markets as a benchmark for establishing the funds rate, which is used to price fixed income products such as corporate bonds and mortgage-backed securities (MBS). Over-the-counter derivatives such as nonvanilla swaps and forex futures are priced based on the information depicted on the swap curve. In addition, the swap curve is used to gauge the aggregate market perception of conditions in the fixed-income market.