What it means
In an interest rate swap, one party pays a fixed rate and the other pays a floating rate that resets over time. The fixed rate that makes the swap fair at the start is called the swap rate, and it differs depending on how long the swap lasts.
Plotting the swap rates for maturities of one year, two years, five years, ten years and so on gives the swap curve. The curve usually slopes upward, because investors normally want higher rates for lending over longer periods.
Sometimes it flattens or inverts, with short-term rates above long-term ones, which is often taken as a signal about the market's expectations for the economy. Its shape therefore carries information about expected future interest rates.
Practitioners use the swap curve in many ways. It is a reference for pricing fixed-rate loans and bonds, for valuing existing swaps and for hedging.
Companies that borrow at floating rates compare the swap rate for the length of their loan with what they pay today to decide whether to fix. The difference between a swap rate and the yield on a government bond of the same maturity is called the swap spread.
It reflects factors such as bank credit risk, demand for hedging and supply of government debt. Analysts watch the spread for signs of stress in the financial system.
The nuance is that the floating rate behind the curve has changed over time, as markets have moved away from older interbank benchmarks to rates based on actual overnight lending. The exact benchmark depends on the currency and the period, so users should check which one a particular curve uses.
Points between the quoted maturities are estimated by interpolation.
In practice
Real-world examples.
Example
A property company has a $50 million floating-rate loan with four years left. The treasurer checks the four-year point on the swap curve and decides to fix the rate, because the swap rate is lower than the interest she expects to pay on average.
Example
A bank prices a fixed-rate loan to a business for three years. It starts with the three-year swap rate and adds a margin for credit risk and costs, so that it earns a profit after hedging.
Example
An analyst notices that the swap curve has flattened sharply over a month. She tells the investment committee that the market expects lower rates in future, and the committee considers extending the maturity of its bond holdings.
Formula
Calculation
Swap spread = swap rate - government bond yield of the same maturity
Annual fixed payment = notional amount x swap rate
Suppose the 5-year swap rate is 4.20% and the 5-year government bond yield is 4.05%. The swap spread is 4.20% - 4.05% = 0.15%, or 15 basis points. A company paying the swap rate on a $20,000,000 notional pays 20,000,000 x 0.042 = $840,000 a year. If the 4-year rate is 4.00% and the 5-year rate is 4.20%, a straight-line estimate for 4.5 years is 4.00% + 0.5 x (4.20% - 4.00%) = 4.10%.Case study
Seen in the real world.
Oakmere Logistics is an illustrative, fictional haulage company with a $30 million floating-rate loan maturing in six years. Its finance director worried that rising rates would raise costs and wanted to see whether fixing made sense.
She obtained the swap curve from the company's bank. The six-year swap rate was 4.30%, while the floating rate currently paid was 3.90%, so fixing would cost an extra 0.40% now, or 30,000,000 x 0.004 = $120,000 a year, in return for certainty.
The board judged that the protection was worth the price after stress testing a rise of 2 percentage points, which would cost $600,000 a year. In this illustrative case, the company agreed the swap, accepting a higher cost today to protect itself against a rate shock.
Watch out
Common mistakes.
- Assuming that the swap curve and the government bond curve are the same, when the gap between them reflects credit risk and other market factors.
- Reading a single point on the curve as a forecast, when it reflects market pricing and risk premiums as well as expectations.
- Ignoring which floating-rate benchmark the curve is based on, which differs by currency and over time.
Questions
People also ask.
What is the swap curve used for?
It is used to price fixed-rate loans and bonds, to value swaps and to hedge interest rate risk.
What does an inverted swap curve mean?
Short-term swap rates are higher than long-term ones, which often indicates that the market expects interest rates to fall in future.
How do you find a rate between two points on the curve?
Analysts usually interpolate, for example by drawing a straight line between the two nearest quoted maturities and reading off the value in between.
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