Swap

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MORGAN STANLEY FIXED INCOME RESEARCH
Morgan Stanley & Co. International Limited

Giles Gale
Primary Analyst Giles.Gale@morganstanley.com +44 (0)20 7677 7121

European Interest Rate Strategy Group
+44 (0)20 7677 7528

July 12, 2005

Interest Rate Products Europe

Asset Swaps and Swap Spreads
Interest Rate Strategy
The spread between swaps and bonds can be traded in many different ways. In this note we describe asset swapping methodologies in detail with particular emphasis on calculation of spreads, risks, and tracking of trades. The spread of bond yields to swaps is also commonly used to evaluate richness and cheapness of bonds of differing maturities. In markets where the analytical power of players is ever growing, methodology is at a premium. The margin for error in using an inappropriate spread in valuation is much greater than the value that is likely to be found. We discuss the risks associated with valuation using tradable and theoretical swap spreads in detail to help users to choose the most appropriate available. Swap spreads to government bonds are actively traded in the market implicitly and explicitly. But the drivers underlying the dynamics of these spreads appear not to be constant and swap spreads vary widely internationally. We discuss the macro and technical factors that may move swap spreads and illustrate these using simple statistical techniques using European and US data. US, European, Japanese and UK 10-year Swap Spreads 160 140 120 100 (bp) 80 60 40 20 0 -20 '96 '97 '98 '99 '00 '01 '02 '03 '04 '05

What’s Inside
Page Introduction Asset Swapping Methodologies Yield/Yield/Asset Swaps Par/Par Asset Swaps Market Value Accrued (MVA) Asset Swaps Box: Asset Swapping Inflation Linked Bonds Yield Accrete or Constant Bond Yield Swap Spreads for Rich-Cheap Analysis Using the Swaps Curve as the Reference for the TermStructure Yield/Yield Par/Par and MVA Swap Spreads Yield Accrete Yield Curve Shift (YCS) Box: Synthetic Par Bonds Swap Spread Dynamics Introduction What Drives Swap Spreads? Why Do Swaps Vary So Widely Internationally? Academic Work Box: The Basis Swap Swap Spread Modelling Questions for the Future Appendix – The Relationship Between MVA and Par/Par Swap Spreads 31 10 10 10 14 14 15 17 17 17 20 23 24 25 30 2 3 3 4 6 8 9 10

US

UK

Germany

Japan

The Primary Analyst(s) identified above certify that the views expressed in this report accurately reflect his/her/their personal views about the subject securities/instruments/issuers, and no part of his/her/their compensation was, is or will be directly or indirectly related to the specific views or recommendations contained herein. This report has been prepared in accordance with our conflict management policy. The policy describes our organizational and administrative arrangements for the avoidance, management and disclosure of conflicts of interest. The policy is available at www.morganstanley.com/institutional/research.

Source: Morgan Stanley

Please see additional important disclosures at the end of this report.

MORGAN STANLEY FIXED INCOME RESEARCH July 12, 2005 Asset Swaps and Swap Spreads Interest Rate Strategy

Introduction
The swaps market has grown extraordinarily quickly since its origins in the early eighties. The market is extremely liquid, and in Europe is now deeper than the government debt market itself in terms of volumes traded. Once quoted as spreads to Governments, the question began to be asked not long ago whether the swaps curve was now the benchmark curve of choice. Certainly in Europe, where the government markets are fragmented, the case is strong. But elsewhere too, the swaps curve’s attractive properties, such as its smoothness and freedom from the complications of benchmarks, repo specialness, and other bond specific idiosyncrasies favour it as the reference curve. As a consequence, the spread to the swaps curve is one of the most common tools for evaluating richness and cheapness of...
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