Swaps and Spreads 101

When you watch the news, one that always goes with figures relating to T-bills are swap spreads. I had a slight notion of what it was but a news article from the Financial Times (Oct 24, 2008) made it clear to me. Take note of the very interesting event that happened yesterday, one that many perceived to be a “mathematical impossibility”. Bolds below are mine.

Turmoil takes its toll on swap markets as spreads turn negative

By Michael Mackenzie in New York

The turmoil in the financial markets has taken hold of the trade in long-term interest rate derivatives, pushing rates to levels once thought to be a “mathematical impossibility”.

Interest rate swaps are the most widely traded over-the-counter derivative.

Long-term swaps are particularly important for insurers and pension funds that need to fund liabilities decades into the future.

Such investors use swaps to lock in interest rates for 30 years or more, trading a floating rate, based on the London interbank offered rate, for a fixed rate.

The fixed rate is typically based on Treasury yields plus a premium, called a swap spread, which reflects the risk of trading with a private party rather than the government.

Yesterday, the 30-year US swap spread turned negative after briefly flirting with such levels earlier this month.

This implies investors are reckoning that they are more likely to be paid back by a private counterparty than by the US government.

“Negative swap spreads have been considered by many to be a mathematical impossibility, just like negative probabilities or negative interest rates,” said Fidelio Tata, head of interest rate derivatives strategy at RBS Greenwich Capital Markets.

Analysts believe that this reflects aftershocks from the demise of Lehman Brothers and capital constraints at surviving banks rather than a loss of confidence in the US government.

The Lehman bankruptcy is important because it led to the termination of outstanding contracts, many highly complex. With many participants scaling back activities, investors have had trouble finding replacements, upsetting the relationship between the swap spread and the “risk-free” Treasury yield.

For much of this year, the 30-year swap spread averaged between 30 and 55 basis points over the 30-year Treasury yield.

It closed at 15bp on Monday, 0.5bp on Tuesday and a negative 4.25bp yesterday.

Implied 30-year swap spreads for Europe and the UK have been negative since the demise of Lehman.

“Insurance companies and pension funds woke up and realised that their existing swap contracts had been torn up and that they needed to replace them,” said William O’Donnell, UBS strategist.

He added that falling swap spreads also reflect the prospect of more Treasuries.

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