I'm interning on a DCM desk this summer. We deal a lot with "pricing sheets" that have a lot of info on swap rates and spreads. I was wondering if someone could help me understand it.
I understand what a swap rate is -- it's the fixed-rate that must be paid so that the swap has an NPV of zero (i.e. I'm a company paying LIBOR+50bps, so I enter into a swap where I receive LIBOR and pay x%...so the x% is the swap rate).
However, I don't really understand from where it's derived or much else about it.
Firstly, I don't get where that swap rate is coming from in the first place. How could there be just one swap rate per maturity when companies can be paying all sorts of different floating rates?
The pricing sheet lists a "swap benchmark" which is just a Treasury bond of a certain tenor (or an interpolation). But I don't really understand what that has to do with the swap rate. I feel like I'm missing something basic here.
Secondly, I don't understand what swap spreads are at all.
Thirdly, what is a BA/$LIBOR basis spread?
Thanks so much. I feel like I should've asked all of these questions on my first day, but now it's too late.
P.S.: Also, if I'm writing that "credit spreads widened," what is meant by credit spreads?
Swaps are quoted under convention. "Industry swaps" are fixed leg against 3 month LIBOR for greater than 1 year maturities, money market conventions for less than one year. The derivation of swap rates depends on a market model: the most simple development, is consider a set of spot rates for times t, t+1, etc.-- From this set of spot rates, we can interpolate future libor rates (we can actually lock in these rates using money market products) and find the present value of these payments. Then we find a fixed rate that pvs to same amount (we assume there's a single fixed rate that NPVs to 0, which isn't actually a mathematical certainty.)
I'm not exactly sure what your pricing sheet lists.
The swap spread is defined as the difference between the swap rate and yield of ("on-the-run") government bonds of equal maturity (default-free bonds). It's a measurement of the difference in valuation of swaps (which are libor valued and have some convexity and credit risk) and treasuries.
BA is another type of funding. The basis is spread is the spread between a swap trading 3 month bankers acceptance against three month libor--I think, not sure what the exact convention is (this is called the BA/Libor basis). Try googling a basis swap.
If "credit spreads widened", it generally means that debt funded by credit or spread products that are correlated with credit have widened, which indicates lesser faith in the credit quality of rated credit.
Thanks! This really helps a lot. I may have more questions though as I work through it. Part of my job has me getting market updates from traders so I want to be able to understand it and not just fake it.
So because swap rates are based off LIBOR/expected LIBOR, swap spreads measure the expected credit-worthiness of financial institutions?
But why use swap spreads to do that? Why not just use LIBOR?
They measure more than the credit worthiness of financial institutions, but that is an essential element of it. The point of a swap spread is that swaps and treasuries are affected by generally the same variables, so that a swap spread measures the difference of variables that affect swaps exclusive of treasuries (recently, those most important has been LIBOR valuation and counterparty risk). Thus, while swap rates can be variable, swap spreads tend to run in a fixed range excepting cases of market crises/market repricings.
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