Question about Swap Spread
i do not know whether it is suitable to post my question here, but if anybody can clarify this question ,i would be very appreciate.
when the treasury yield curve spread becomes large (10-yr minus 2 yr ), the market expect the forward rate go up ,as for the LIBOR, so the swap rate also increase, but why the swap spread can increase too ? if the bechmark treasury curve goes up with the libor curve, the relative spread between treasury and swap maynot be definitely becomes largeer.
dude - do your own homework.
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I guess after the last comment I made, I better take a crack at this.
When figuring out the swap rate you basically take 1 minus the discount factor from the last period of the swap divided by the sum of the discount factors from every period of the swap. (1-disc factor period n) / (disc factor period 1 + disc factor period 2 +.....+ disc factor period n)
When rates are higher, discount factors are lower (ill explain why in a bit). So according to the formula above, with larger discount factors, the numerator will be lower at a bigger proportion than the denominator will be lower; hence resulting in a lower swap rate.
The discount factor for each treasury maturity is calculated as 1 / [1 + treas rate * (days till maturity on treas/360) so as treas rate is higher, the denominator is higher, which results in a smaller discount factor.
Try this relationship out with 2-4 periods using one set of treasury rates, then again with a higher set of rates. You will see that as you increase your underlying treasury rates the end result which is the swap rate will grow as well.
Hope that helps.
I think he understands that the swap rate will increase, but he's curious as to why the spread b/w the two curves increases if the curves generally move in tandem. I would think it is b/c of the word "generally" here. While the libor rates off of which the swap rate is determined increases, but the treasury stays about the same, the spread will increase, as the fixed rate on the swap is recalculated per trailmix's method. The swap curve is thought to be a better indication of risk and liquidity in the banking system overall b/c there is less regulation, government intervention, and no need ot adjust the rates for soveriegn debt risk between countries.
I think the short answer is that while the treasury curve and swap curve usually move together, they do not always move together and with the same magnitude.
thanks a lot for your words, indeed, the treasury yield movement may not be easily and accurately described, but it can move with the libor curve in the same direction
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