Swap Spread

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  • Topic: Interest rate swap, Yield curve, Swap
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Interest Rate Swaps
October, 2007
Primary Analyst: Jason Stipanov
(212)-761-2983
jason.stipanov@morganstanley.com
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. Please see additional important disclosures at the end of this report.

Interest Rate Swaps
The Structure of a Swap

2

See additional important disclosures at the end of this report.

What is a Swap?
Spot-Starting 5-Year Fixed/Floating Swap ($100MM Notional)
Fixed Payments
Party A

5.05% Semiannually on 30/360-Day Count
3-Month LIBOR Quarterly on Act/360-Day Count

Party B

Floating Payments


Swap: Contractual agreement to exchange fixed for floating cash flows over a specified period of time



Floating rate reference: USD LIBOR



LIBOR: British Banker Association’s (BBA) fixing of the London Inter-Bank Offered Rate. A contributor bank contributes the rate at which it could borrow funds, if it were to do so by asking for and accepting inter-bank offers in reasonable market size just prior to 11 AM London time. 16 banks contribute, the top and bottom 4 fixings are eliminated, and the remaining 8 fixings are averaged. 3

See additional important disclosures at the end of this report.

A Cashflow Example
Swap rate = average of expected LIBOR settings
Suppose You Pay Fixed on a 2-year Swap at a Rate of 4.83%
Floating Leg

Fixed Leg

3M LIBOR = 5.21% (Quarterly, Actual/360)
3M LIBOR in 3 months

4.83% (Semi, 30/360)

3M LIBOR in 6 months
3M LIBOR in 9 months

4.83% (Semi, 30/360)

3M LIBOR in 1 year
3M LIBOR in 1YR 3M

4.83% (Semi, 30/360)

3M LIBOR in 1YR 6M
3M LIBOR in 1YR 9M

4

4.83% (Semi, 30/360)

See additional important disclosures at the end of this report.

A Swap is Similar to a Leveraged Bond
Similar to a leveraged bond transaction
Swap Transaction Is Similar to a Bond Transaction
Combined with 3-Month Financing
Receive Fixed on a Swap

You
Pay LIBOR

UST Rate (buy bonds)

You
Pay Repo

5

See additional important disclosures at the end of this report.

A Swap Is Different from a AA Bank Bond
An interest rate swap has different characteristics compared to a AA bank bond •

Differences between a swap contract and a AA bank bond






Swap: No risk of principal loss or default
Swap: Less risk of downgrade (if a bank is downgraded, it will be thrown out of the LIBOR panel)
Swap: Majority of trades are collateralized, thus reducing counterparty risk

Result: Swap rates trade richer than AA bank credits
Components of Corporate Bond Treasury Spread
Swap Spread =
Systemic Risk
Company
Specific Risk

6

See additional important disclosures at the end of this report.

Determining Future Expectations of LIBOR


How Do We Determine Expectations of Future 3M LIBOR
Settings?



Out to 5 years, we use Eurodollar contracts:
Forward contracts on 3M LIBOR
− Liquidity exists out to 5 years
− Convexity issue




Beyond 5 years, expected 3M LIBOR settings are implied
from the swap rates.

7

See additional important disclosures at the end of this report.

Generating the Swap Curve
From the Eurodollar Futures and Market Traded Swap Rates, a Swap Curve Is Generated
The swap curve is smooth and continuous, unlike government bond curves 0.058
0.056
0.054

Swap spread

0.052
0.05
0.048
0.046
Swap Rate

0.044

Tsys

0.042
0.04
October...
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