What is a Swap Spread
A swap spread is the difference between the fixed component of a given swap and the yield on a sovereign debt security with a similar maturity. In the U.S, the latter would be a U.S. Treasury security. Swaps themselves are derivative contracts to exchange fixed interest payments for floating rate payments.
Because a Treasury bond is often used as a benchmark and its rate is considered to be default risk-free, the swap spread on a given contract is determined by the perceived risk of the parties engaging in the swap. As perceived risk increases, so does the swap spread. In this way, swap spreads can be used to assess the creditworthiness of participating parties.
BREAKING DOWN Swap Spread
Swaps are contracts that allow people to manage their risk in which two parties agree to exchange cash flows between a fixed and a floating rate holding. Generally speaking, the party that receives the fixed rate flows on the swap increases his/her risk that rates will rise. At the same time, if rates fall, there is the risk that the original owner of the fixed rate flows will renege on his/her promise to pay that fixed rate. To compensate for these risks, the receiver of the fixed rate requires a fee on top of the fixed rate flows. This is the swap spread.
The greater the risk of breaking that promise to pay, the higher the swap spread.
If a 10-year swap has a fixed rate of four percent and a 10-year Treasury note with the same maturity date has a fixed rate of three percent, the swap spread would be one percent (100 basis points) (4% - 3% = 1%).
Swap spreads correlate closely with credit spreads as they reflect perceived risk that swap counterparties will fail to make their payments.
Swap Spreads as an Economic Indicator
In the aggregate, supply and demand factors take over. The more people who want to swap out of their risk exposures, the more they must be willing to pay to induce others to accept that risk. Therefore, larger swap spreads means there is a higher general level of risk aversion in the marketplace. It is also a gauge of systemic risk.
When there is a swell of desire to reduce risk, spreads widen excessively. It is also a sign that liquidity is greatly reduced as was the case during the financial crisis of 2008. Swap spreads are essentially an indicator of the desire to hedge risk, the cost of that hedge, and the overall liquidity of the market.