Spread Swap spreads

Swap spreads are quoted off specific government benchmarks. When a benchmark issue is replaced, it can have a technical effect on swap spreads. Swap spreads can either narrow or widen, depending on the new benchmark issue used and the shape of the yield curve. The change is only technical, however, and absolute swap rate levels remain unchanged. 

Asset-Swap Spreads and Relative Value Analysis... 

Asset-swap spread 1 1.5 Analysis using market ... 

A bond s swap spread is a measure of the credit risk of a bond relative to the interest-rate swap market. Because the swap is traded by banks, or interbank market, the credit risk of the bond over the interest-rate swap is given by its spread over the IRS. In essence, then the IRS represents the credit risk of the interbank market. If an issuer has a credit rating superior to that of the interbank market, the spread will be below the IRS level rather than above it. 

At the same time, the investor enters in the swap contract, paying fixed cash flows equal to the coupon payment and receiving a fixed spread over the interbank rate, that is the asset-swap spread. Figure 1.1 shows the asset-swap mechanism. 

The zero-coupon curve is used in the asset-swap analysis, in which the curve is derived from the swap curve. Then, the asset-swap spread is the spread that allows us to receive the equivalence between the present value of cash flows and the current market price of the bond. 

Making comparison between bonds could be difficult and several aspects must be considered. One of these is the bond s maturity. For instance, we know that the yield for a bond that matures in 10 years is not the same compared to the one that matures in 30 years. Therefore, it is important to have a reference yield curve and smooth that for comparison purposes. However, there are other features that affect the bond s comparison such as coupon size and structure, liquidity, embedded options and others. These other features increase the curve fitting and the bond s comparison analysis. In this case, the swap curve represents an objective tool to understand the richness and cheapness in bond market. According to O Kane and Sen (2005), the asset-swap spread is calculated as the difference between the bond s value on the par swap curve and the bond s market value, divided by the sensitivity of 1 bp over the par swap. 

As shown in Eigures 1.4 and 1.5, with this swap structuring, the asset-swap spread for HERIM is 39.5 bp and for TKAAV is 39.1 bp. These represent the spreads that will be received if each bond is purchased as an asset-swap package. In other words, the ASW spread provides a measure of the difference between the market price of the bond and the value of the cash flows evaluated using zero-coupon rates. 

FIGURE 1.7 Historical asset-swap spread for bonds traded in the utility industry. (Data Source Bloomberg.)... 

For the calculation, we cancel out the principal payments of par at maturity. We assume that cash flows are annual and take place on the same coupon dates. The breakeven asset-swap spread A is calculated by setting the present value of all cash flows equal to 0. From the perspective of the asset swap seller, the present value is ... 

Choudhry, M., 2005. An alternative bond relative value measure determining a fair value of the swap spread using libor and gc repo rates. J. Asset Manag. 7 (1), 17-21. 

Where Y is the yield of a corporate bond 1 is the /-spread over the swap S is the swap spread and T is the yield of a treasury bond ... 

Asset-swap spread It is determined by combining an interest-rate swap and cash bond. Generally, bonds pay fixed coupons therefore, it will be combined with an interest-rate swap in which the bondholder pays fixed coupons and receives floating coupons. The spread of the floating coupon over an interbank rate is the asset-swap spread. ... 

Figure 8.2 shows the Bloomberg YAS page for Tesco bond SVi% 2019, as at October 9, 2014. The bond has a price of 109.345 and yield to maturity of 3.46%. On the date, the yield spread over a government bond benchmark UK 41 % Treasury 2019 is 200 basis points. The G-spread over an interpolated government bond is 181.5 basis points. Conventionally, the difference between these two spreads is narrow. We see also that the asset-swap spread is 173.6 basis points and Z-spread is 166.3 basis points. 

Chapter 8 shows several spread measures that can be used to compare fixed-rate bonds. Conventionally for floating-rate notes, traders use the discounted margin. To analyse a floating-rate note with a fixed-rate note, one method is to compare the discounted margin of a floater with the asset swap spread of fixed-rate bonds. 

What is worthy then of a further investment of cash to purchase this second edition Hopefully the new chapters on asset swap spread relative value, convertible bonds, callable/putable bonds and floating-rate notes will be sufficient justification additionally we have updated the previous chapters on inflation-linked bonds and risky corporate bonds valuation. We have also included Excel spreadsheets that enable the reader to apply the analysis described in the chapters right away to bonds that he or she selects. 

The evolution of Euro government bond swap spreads has always been linked to the performance of the peripheral spreads (or vice versa). Yet this relationship should be taken with a pinch of salt as, having the German rate in both sides of the equation, a simple spike in the German market bond volatility will make this correlation increase spuriously. 

That said, there are two reasons why the performance of German swap spreads are related to Euro peripheral spreads. The first one is that, flows apart, the bond-swap spread reflects the yield difference between a government rate and the composition of a string of EURI-BOR rates (i.e., a swap fixed rate). As the average credit quality of the banks in the EURIBOR panel is A-AA, any increase in the investors preference for credit quality will make both swap and peripheral spreads widen versus the core Euro government rate, thus increasing the correlation between both differentials. Yet this increase in the correlation will be mainly due to the outperformance of the benchmark asset... 

Rates Source Bloomberg L.P. EXHIBIT 7.6 Jumbo-Swap Spreads... 

Given the swap rate, the swap spread can be determined. For example, since this is a 3-year swap, the convention is to use the 3-year rate on the euro benchmark yield curve. If the yield on that issue is 4.5875%, the swap spread is 40 basis points (4.9875% - 4.5875%). 

As we have seen, interest rate swaps are valued using no-arbitrage relationships relative to instruments (funding or investment vehicles) that produce the same cash flows under the same circumstances. Earlier we provided two interpretations of a swap (1) a package of futures/forward contracts and (2) a package of cash market instruments. The swap spread is defined as the difference between the swap s fixed rate and the rate on the Euro Benchmark Yield curve whose maturity matches the swap s tenor. 

Exhibit 19.11 presents Bloomberg s World Swap screen which presents swap spreads for various countries around the world for June 27, 2003. In this screen, the tenor of the swaps in this screen is five years as can be seen in the box labeled Maturity in the upper left-hand corner. Among the other choices available, a user can choose to display swap rates rather than spreads. Exhibit 19.12 is a time series plot obtained from Bloomberg for daily values of the 5-year euro swap spread (in basis points) for the period June 27, 2002 to June 27, 2003. 

EXHIBIT 19.12 Time Series of the 5-Year Swap Spread... 

Naturally, this presupposes the reference rate used for the floating-rate cash flows is EURIBOR. Furthermore, part of swap spread is attributable simply to the fact that EURIBOR for a given maturity is higher than the rate on a comparable maturity benchmark government. 

The default risk component of a swap spread will be smaller than for a comparable bond credit spread. The reasons are straightforward. First, since only net interest payments are exchanged rather than both principal and coupon interest payments, the total cash flow at risk is lower. Second, the probability of default depends jointly on the probability of the counterparty defaulting and whether or not the swap has a positive value. See John C. Hull, Introduction to Futures and Options Markets, Third Edition (Upper Saddle River, NJ Prentice Hall, 1998). 

The first section describes the motivation for using the swap term structure as a benchmark for pricing and hedging fixed-income securities. The second section examines the factors that affect swap spreads and swap market flows. The third section describes a swap term structure derivation technique designed to mark to market fixed-income products. Finally, different aspects of the derived term structure are discussed. 

Swap rates (frequently quoted as government bond yield for a chosen benchmark adjusted for swap spreads)... 

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