I am curious to understand this, in US when we price bonds against treasury (that's say a proxy for being risk free) and then add a spread over it for the riskiness of the issuer based on credit rating etc.
What does mid swap in bond pricing imply? I don't understand why there is a swap involved here at all? What is getting swapped?
I tried to hunt online but bond pricing is more like a DCF in all the books I could get my hands on. Appreciate all help, really stuck here!
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"mid swap" is just another way of saying "the matched maturity interest swap rate"
Swap rates are calculated from the swap curve...and the swap curve is built from a set of market points. There are liquid markets for benchmark swap spreads (spreads between government bonds and the swap curve)....so you add these spreads to government bond yields to get the benchmark swap rates (2yr, 3yr, 5yr, 7yr, 10yr, 20yr, 30yr). With these swap rates, you can construct a swap curve (a curve is a mathematical model that will give you a rate for any tenor).
So, you construct a swap curve from the benchmark swap spreads, and can now calculate a swap rate for any tenor (say 8.5 years). So, now with your 8.5yr swap rate....you can add a spread (say 35 bps).....and now you have a swap + 35 bps = your bond spread to swaps.
Why do this? There are a few reasons. Theoretically, the swap curve is based on the premise of a set of rates that banks would use to lend to each other...and these rates can be switched between fixed and floating...so its a convenient benchmark for some things. Also, there is limited supply of government bonds for some tenors...and sometimes this causes supply/demand price distortions....but there is no such supply/demand limit for swaps.
Do you have a resource that does a deep dive on this topic? Thanks.
both fabozzi and tuckman wrote books that go over the basics of interest rates...i'm not sure if there is a deep dive on this specific topic...but when you understand the whole market, you'll be able to figure it out
thank you, thank you for giving such a clear explanation. The limited govt bond for various tenors makes sense. There are two further questions if I may-
a) When we price a bond, then do we deduct the riskiness of the swap (as it isn't completely risk-free like a govt bond) and then add a spread for the issuer's risk? b) you mentioned that the rates can be switched from fxd to floating- what can this be useful for in context of bonds?
Thanks for your help!
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