The swap spread is obtained by taking the difference between a swap’s fixed leg rate and the yield on a recently issued government bond (“on the run issue”) with the same maturity. Swap spreads can be used to value bonds.

The fixed interest rate payer pays the swap spread. Swap spreads across maturities can be used to measure the creditworthiness of major banks that provide swaps.

Assume that the fixed leg rate of a six-year fixed-for-float Libor swap is 5.00% and the six-year US Treasury bond yield is 4.60%. The swap spread will be 5.00% – 4.60% = 0.40%.

Investors use the swap spread to identify the time value, credit, and liquidity components of a bond’s yield to maturity. They will require higher compensation for credit and liquidity risks when the swap spread is high.

The swap spread can be used to indicate the liquidity of a default-free bond and can also provide evidence of market mispricing.

## Question

The four-year fixed-for-floating LIBOR swap rate is 4.62%, and the yield on the four-year US Treasury bond is 4.41%. The swap spread is closest to:

1. 0.105%.
2. 0.210%.
3. 4.515%.

Solution

\begin{align*} \text{Swap spread} & = \text{Swap rate}\ – \text{Government bond yield } \\ &=4.62\%\ – 4.41\% = 0.21\% \text{ or } 21 \text{ bps} \end{align*}

Reading 28: The Term Structure and Interest Rate Dynamics

LOS 28(f) Calculate and interpret the swap spread for a given maturity.

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