What Is A Swap Curve?
A Swap Curve is a chart that graphically represents the swap rate returns at different maturity dates. Therefore, this curve provides a comprehensive view of the market expectations and serves as a reference point for various financial decisions and strategies.
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Source: Swap Curve (wallstreetmojo.com)
The plotted lines are similar to the yield curve; it typically goes from bottom to top in an upward-sloping structure because long-term swap returns tend to grow with time and maturity dates. As a result, a swap curve is a powerful indicator in fixed-income markets to depict bank credit and LIBOR expectations, and market analysts treat it as a significant benchmark.
Table of Contents
- What Is A Swap Curve?
- Swap Rate Curve Explained
- How To Create?
- Examples
- Swap Curve vs Yield Curve vs Forward Curve
- Frequently Asked Questions (FAQs)
- Recommended Articles
Key Takeaways
- The swap curve depicts the relationship between swap rates at different maturity points in the fixed-income market.
- One can create this curve in Excel to gain an understanding of the time value of money and analyze prevailing and future market conditions, particularly for different maturity dates.
- Therefore, this curve is equivalent to a yield curve, but it exhibits a difference in the swap spread between them.
- To construct this curve, one should plot the fixed rates of a series of interest rate swaps against their respective maturities.
Swap Rate Curve Explained
The swap curve is the plotted graphical representation of all the maturities available concerning time and varying market rates. By planning and studying the graph, an investor can visualize the future returns and market interest rates and based on that, can make better financial decisions. Hence, the participants construct the curve using interpolation, bootstrapping, and algorithms. Thus, the swap curve for inflation represents the relationship between fixed rates of inflation swaps and their maturities.
Furthermore, a forward swap curve measures the price of fixed-income instruments like mortgage-backed securities and corporate bonds, including cash flows, OTC (over the counter) derivatives, and non-vanilla swaps. Besides, participants also use it to perform valuation, spot potential trading opportunities, manage risk, and analyze market sensitivity.
Therefore, swap contracts have a vast default risk and lack of liquidity, so the swap curve plays a key role and is a benchmark for understanding swap markets. There is always a choice between these curves and government bond spot curves. Wholesale banks hedge many items on their balance sheets; therefore, they study swap curves. In contrast, retail banks use government spot curves instead due to low exposure to swap markets.
Thus, the importance of forward swap curves lies in elaborating the time value of money for different financial instruments. When two parties enter into a derivative contract, they include default risk. For example, a company offering variable interest may swap its interest payments with another company, paying the first company a fixed interest rate.
How To Create?
This curve comprises market interest rates extracted from the instruments that underlie the liquid and dominant mechanisms across various time horizons. An interpolation algorithm bootstraps and combines these rates.
In swap curve construction, we subdivide these into three sets.-
- The short end derived from the interbank deposit rates (for less than three months)
- The middle area is future contracts’ interest rates or forward rate agreements (FRAs). (From three months to two years)
- Finally, one can construct the long end of the curve by using par swap rates sourced from the swap market. (For ten years or more).
- One payment stream fixes the interest rate, while the other stream floats based on an interest rate.
Therefore, here’s a step- by step process to create this curve:
- Firstly, one can obtain swap rate data by collecting it from financial data providers, trading platforms, or market publications.
- Secondly, they can plot the swap rates on the curve to determine the specific maturities.
- Hence, they can identify the corresponding swap rate from the collected data for each selected maturity.
- Later, they can plot the swap rate on a graph using the vertical axis and the selected maturities on the horizontal axis.
- Lastly, they can analyze the shape, slope, and level of the plotted curve.
Examples
Let us understand the concept better with the help of an example.
Example #1
For swap curve construction, suppose that the swap rate for different maturities is –
| Year | Swap rate |
|---|---|
| 1 | 3.15% |
| 2 | 5.49% |
| 3 | 6.39% |
Based on this, the lines plotted on a curve will be –
You are free to use this image on your website, templates, etc, Please provide us with an attribution linkHow to Provide Attribution?Article Link to be Hyperlinked
For eg:
Source: Swap Curve (wallstreetmojo.com)
The graph is a simple representation of the varying market swap rates along with extending maturity dates. The x-axis is used to set the maturity dates, while the y-axis notes the swap rates, typically displaying an upward slope. However, the real-world curves may vary depending on the market conditions.
Example #2
The market predictions for 2023 are heavy for US issuance, and the economic recession is predicted not to contribute to it. The supply drastically affects US swap spreads, and there will be cuts in federal and corporate issuances. Analysts are forecasting that the shape of the US swap spread curve will remain highly inverted throughout the entire year 2023.
Not being the only reason, but the SOFR (Secured Overnight Financing Rate Data) swap curve is also playing a part in the situation. The US redemption shows $2.6 trillion in Treasuries funding and $160 billion in TIPS for 2023. When the fiscal year of 2022 ended, there was a deficit of $1.4 trillion. For 2023 it is projected at 4.6% in gross domestic product (GDP).
Swap Curve vs Yield Curve vs Forward Curve
- A swap curve is used for derivatives to exchange multiple cash flows. In contrast, the yield curve measures bond investors’ risk, but the forward curve is employed to exchange a single cash flow on a future date.
- Hence, this curve is used for pricing and valuation of interest rate derivatives, managing interest rate risk, and analyzing market sentiments. In contrast yield curve is used to assess interest rate levels, evaluate economic conditions, price bonds, and explore the shape of the curve. A forward curve predicts future interest rates and price forward rate agreements, along with formulating hedging strategies.
- These curves are divided into base and basis swap curves. In comparison, the yield curve is of three types: upward-sloping, flat, and inverted. Again, the forward curve is of two types: standard and inverted.
Frequently Asked Questions (FAQs)
Time is one of the most critical factors that affect this curve. Therefore, the swap rates are sensitive to the term period. Therefore, if the maturity term is low, there will be less variation in the market interest rate. In contrast, the longer the maturity term is, the greater it influences the fluctuations in the interest rate.
The swap curve is used –
– To understand financial markets and predict swap rates at different maturity dates.
– It is a primary benchmark for pricing loans, bonds, and mortgages.
– Allows investors to hedge their risk.
Bootstrapping this curve involves using market data on swap rates to infer the zero-coupon yield curve. Here are a few steps to follow,
• Gather swap rate data.
• Determine swap instruments
• Calculate discount factors
• Interpolation and Extrapolation
• Check consistency
Recommended Articles
This has been a guide to what is a Swap Curve. Here, we compare it against the yield curve and forward curve, explain its examples, and how to create it. You can learn more about it from the following articles –
- Swaption
- Currency Swap
- Asset Swap
This post first appeared on Free Investment Banking Tutorials |WallStreetMojo, please read the originial post: here
