swaps and swap spreads

An interest-rate swap is a transaction between two so-called counterparties in which fixed and floating interest-rate payments on a notional amount of principal are exchanged over a specified term. One counterparty pays interest at a fixed rate and receives interest at a floating rate (typically three-month Libor). The other pays interest at the floating rate and receives the fixed-rate payment. A swap can give both counterparties a lower cost of money than could be obtained from investors, at least initially.

If interest rates subsequently rise, pushing floating rates higher, the fixed-rate payer obtains additional savings at the expense of the floating-rate payer. Conversely, if rates move lower, the floating-rate payer obtains additional savings at the expense of the fixed-rate payer.

A swaps dealer is typically one of the counterparties. Swaps dealers hedge their risk by entering into some transactions where they pay a fixed rate and others where they pay a floating rate. The dealers profit from the difference between the fixed rate they are willing to pay and the fixed rate they demand.

A swap spread is the difference between the fixed interest rate and the yield of the Treasury security of the same maturity as the term of the swap. For example, if the going rate for a 10-year Libor swap is 7% and the 10-year Treasury note is yielding 6%, the 10-year swap spread is 100 basis points. Swap spreads correlate closely with credit spreads. They reflect perceived risk that swap counterparties will fail to make their payments.

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