Swap spreads market

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. 

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. 

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. 

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. 

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. 

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. 

Declines in equity market values tend to place upward pressure on swap spreads. A decline in equity market values deteriorates the overall credit health of the banking sector, because it reduces collateral value in the entire system. 

An interesting development in the credit default swap market is the response of protection sellers to credit events, the impact is ultimately reflected in the price of credit default swaps, as reflected by the credit default swap spread. Credit derivative markets have experienced spread widening at times of bad credit related news, in effect this reflects the protection sellers pricing the risk of the additional probability of a credit event into the protection they sell. 

The pricing of credit default swaps is determined in the credit default swap market by traders who determine the credit default swap spread through their assessment of the default risk of the reference obligations. This spread information can give valuable information about the key pricing components of the reference credit implied probability of default of the reference credit and recovery assumptions. These price... 

CDS prices are often compared to bond asset swap levels in order to gain an initial comparison of the credit quality implied by the market. In fact, differences do exist between the CDS spread and the asset swap spread, even though both spreads may be viewed as compensating the... 

However, it is also possible that an investor may find that there is a negative basis. For example, the credit default swap spread is less than the asset swap level for a cash instrument issued by the same reference entity. This situation may arise in the markets ... 

If an investor s funding cost is above LIBOR, then selling protection would appear more attractive than carrying a cash position and experiencing a reduced carry on the bond returns due to the funding cost. Many players in the credit default swap markets fund above LIBOR and it would seem that selling protection may cause default swap spreads to narrow. 

The reader may notice that the value of the example default swap is close to zero this is not coincidental and does warrant some explanation. It is often heard in the market that default swap spreads are representative of default probabilities—it is clear from our example that the hazard rate, X, equals 5.00%, but the premium of the default swap is only 4.00%. The reason for this discrepancy is not complex and resnlts directly from our assumption of the recovery value, R = 20%. 

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. 

Swap spread volatilities for several currencies are shown in Exhibit 23.6, with values that vary from about 15 bp/year to 40 bp/year. Also shown are the resulting spread risks in the euro and sterling markets for several rating categories. We will see further below that the swap model predicts reasonably accurately both the absolute magnitude of the spread risk in each market and their relative values. 

Panel A Swap Spread Annualized Volatility for Markets Covered in the Model... 

Swap spread correlation with credit spreads has been a topic of discussion ever since the credit market took off in Europe. Of late, this correlation... 

During the financial crash of2007—2008, in reaction to bond market volatility around the world brought about by the bank liquidity crisis and subsequent global recession, the USD swap spread widened, as did the spread between 2- and 10-year swaps, reflecting market worries about credit and counterparty risk. Spreads narrowed in the first quarter of 2009, as credit concerns sparked by the 2007—2008 market corrections declined. The evolution of the 2- and 10-year USD swap spreads is shown in FIGURES 7.4 and 7.5. 

This is the traditional strategy that relies on picking names that are expected to outperform the market. In fund management terms, one selects a diversified portfolio of credits, which ensures that systemic market risk (beta) is hedged away, while the performance of the fund generates excess return, or alpha. Names that are expected to outperform are trading at levels that are cheap, in relative value terms, to their industry or sector class. This is measured by the asset swap spread or ASW, as we observed earlier. 

A bond s swap spread is a measure of the credit risk of that bond, relative to the interest-rate swaps market. Because the swaps market is traded by... 

An asset swap is a package that combines an interest-rate swap with a cash bond, the effect of the combined package being able to transform the interest-rate basis of the bond. Typically, a fixed-rate bond will be combined with an interest-rate swap in which the bond holder pays fixed coupon and received floating coupon. The floating coupon will be a spread over LIBOR (see Choudhry et al. 2001). This spread is the asset-swap spread and is a function of the credit risk of the bond over and above interbank credit risk. Asset swaps may be transacted at par or at the bond s market price, usually par. This means that the asset swap value is made up of the difference between the bond s market price and par, as well as the difference between the bond coupon and the swap flxed rate. 

Put simply, the Z-spread is the basis point spread that would need to be added to the implied spot yield curve such that the discounted cash flows of the bond are equal to its present value (its current market price). Each bond cash flow is discounted by the relevant spot rate for its maturity term. How does this differ from the conventional asset-swap spread Essentially, in its use of zero-coupon rates when assigning a value to a bond. Each cash flow is discounted using its own particular zero-coupon rate. The bond s price at any time can be taken to be the market s value... 

The spread of the floating coupon over the bond s market price, that is the asset-swap value is the difference between the bond s market price and par. The package of the asset swap is structured in two phases ... 

Z-spread is an alternative spread measure to the ASW spread. This type of spread uses the zero-coupon yield curve to calculate the spread, in which in this case is assimilated to the interest-rate swap curve. Z-spread represents the spread needful in order to obtain the equivalence between the present value of the bond s cash flows and its current market price. However, conversely to the ASW spread, the Z-spread is a constant measme. 

A credit default swap (CDS) price provides fundamental credit risk information of a specific reference entity or asset. As explained before, asset swaps are used to transform the cash flows of a corporate bond for interest rate hedging purpose. Since the asset swaps are priced at a spread over the interbank rate, the ASW spread is the credit risk of the same one. However, market evidence shows that credit default swaps trade at a different level to asset swaps due to technical... 

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