Swap spreads factors

First, as mentioned earlier, there is usually no universal benchmark in a given market. Again, a possible approach, used in Barra s models, is to introduce a swap spread factor that describes the average spread between sovereign and swap rates and can conveniently allow spread risk to be expressed with respect to the LIBOR/swap curve when interest rate risk factors are originally based on the sovereign yield curve. 

Credit spreads are computed with respect to the local swap curve to accommodate for the swap spread factor. 

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. 

Empirically, there are several factors that affect swap spreads. These factors drive swap flows, pricing, and hedging methods of swap markets. The main factors and their impact on swap spreads are described below. 

There are a large number of other factors that can have an impact on swap spreads. Each factor can have varying effects on swap spreads over time. Institutional investors and hedge funds continuously develop forward-looking models that incorporate different factors in an attempt to predict swap spread movements for speculation purposes. 

At the time of this writing, corporate bonds denominated in currencies others than euro and sterling are only exposed to the local interest factors and if it exists, the swap factor. This swap factor is roughly equivalent to a financial AA spread factor, as the bulk of organizations that engage in swaps are AA-rated financial institutions. The swap model is coarser than the two local credit models discussed in the next section, but it performs adequately because spread changes are highly correlated within markets. 

This same factor can also be used to compute spread risk in markets where there is not enough data to build a detailed credit block. It can also be used in markets where more detailed credit factors are available, but when there is not enough information to expose a bond to the appropriate credit factor. As we will see in what follows, this will be the case when a euro- or sterling-denominated corporate bond is not rated. Based on the observation that bonds with larger spreads are on average more risky, Barra s model assumes the following exposure to the swap factor ... 

Panel B Comparison between Typical Euro and Sterling Spread Volatilities Computed Using the Swap Factor for Different Rating Categories... 

We compare in Exhibit 23.16 the volatilities of a few selected euro and US dollar factors. The common denominator is that euro volatilities are less than their US dollar counterparts. This is true for all factors if we ignore the volatility bursts sometimes observed over a few months for some factors (for instance the Industrial A factor in Exhibit 23.16). The average level of systematic risk observed amongst euro-denomi-nated fixed income instruments is more generally low compared to other markets. Exhibit 23.16 shows one case where euro volatilities seem to be catching up with US levels. A more systematic analysis of how euro volatilities have recently evolved since 2002 would show that this is an exception. On average, euro volatilities have remained low with respect to US ones. Note that this is consistent first with the predictions of the swap factor model, euro spread levels and swap volatility being low compared to other markets. 

Several borrowers issue bonds in multiple currencies, which tend to trade at different spreads, even on a fully asset swapped basis. The reasons for this divergence include name recognition, and technical factors such as liquidity and the ability to enter into a repo. 

The guarantor in a TR swap usually pays the beneficiary a spread over LIBOR. Pricing in this case means determining the size of the LIBOR spread. This spread is a function of the following factors ... 

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